Unformatted text preview: 9160335_CH06_p125-148.qxd 6/22/09 8:58 AM Page 125 6 Government Actions in
Markets After studying this chapter,
y ou will be able to:
■ Explain how rent ceilings create housing shortages and
inefficiency ■ Explain how minimum wage laws create unemployment
and inefficiency ■ Explain the effects of a tax ■ Explain the effects of production quotas and subsidies on
production, costs, and prices ■ Explain how markets for illegal goods work Even though house prices are falling, home renters In some markets, governments intervene with the oppo- in New York, San Francisco, and Boston saw their rents rise by site of a tax: a subsidy. For example, in the market for farm an average of 10 percent in 2007. Can governments cap rents products, the U.S. government subsidizes producers to to help renters live in affordable housing? Or instead, can gov- lower the price faced by consumers. Sometimes, govern- ernments make housing more affordable by raising incomes ments limit the quantities that farms may produce. Do subsi- with minimum wage laws? dies and production limits help to make markets efficient? Taxes put the hand of government in almost every pocket Price caps, tax cuts, and subsidies, three of the major topics and market. We pay income taxes and Social Security taxes that you study in this chapter, have been proposed as ways of in the labor market and sales taxes in the markets for almost dealing with the high price of gasoline. In Reading Between the everything we buy. You probably think that you pay more Lines at the end of this chapter, we apply what you’ve learned than your fair share of taxes. But who actually pays and who to the market for gasoline to see how governments might try to benefits when a tax is cut: buyers or sellers? influence the price and quantity in that market. 125 9160335_CH06_p125-148.qxd 126 6/22/09 8:58 AM Page 126 CHAPTER 6 Government Actions in Markets ◆ A Housing Market With a
We spend more of our income on housing than on
any other good or service, so it isn’t surprising that
rents can be a political issue. When rents are high,
or when they jump by a large amount, renters might
lobby the government for limits on rents.
A government regulation that makes it illegal to
charge a price higher than a specified level is called a
price ceiling or price cap.
The effects of a price ceiling on a market depend
crucially on whether the ceiling is imposed at a level
that is above or below the equilibrium price.
A price ceiling set above the equilibrium price has
no effect. The reason is that the price ceiling does
not constrain the market forces. The force of the law
and the market forces are not in conflict. But a price
ceiling below the equilibrium price has powerful
effects on a market. The reason is that the price ceiling attempts to prevent the price from regulating the
quantities demanded and supplied. The force of the
law and the market forces are in conflict.
When a price ceiling is applied to a housing market, it is called a rent ceiling. A rent ceiling set below
the equilibrium rent creates
■ A housing shortage
Increased search activity
A black market A Housing Shortage
At the equilibrium price, the quantity demanded
equals the quantity supplied. In a housing market,
when the rent is at the equilibrium level, the quantity of housing supplied equals the quantity of housing demanded and there is neither a shortage nor a
surplus of housing.
But at a rent set below the equilibrium rent, the
quantity of housing demanded exceeds the quantity
of housing supplied—there is a shortage. So if a rent
ceiling is set below the equilibrium rent, there will be
a shortage of housing.
When there is a shortage, the quantity available is
the quantity supplied and somehow, this quantity
must be allocated among the frustrated demanders.
One way in which this allocation occurs is through
increased search activity. Increased Search Activity
The time spent looking for someone with whom to
do business is called search activity. We spend some
time in search activity almost every time we make a
purchase. When you’re shopping for the latest hot
new cell phone, and you know four stores that stock
it, how do you find which store has the best deal? You
spend a few minutes on the internet, checking out
the various prices. In some markets, such as the
housing market, people spend a lot of time checking
the alternatives available before making a choice.
When a price is regulated and there is a shortage,
search activity increases. In the case of a rent-controlled housing market, frustrated would-be renters
scan the newspapers, not only for housing ads but
also for death notices! Any information about
newly available housing is useful, and apartment
seekers race to be first on the scene when news of a
possible supplier breaks.
The opportunity cost of a good is equal not only to
its price but also to the value of the search time spent
finding the good. So the opportunity cost of housing
is equal to the rent (a regulated price) plus the time
and other resources spent searching for the restricted
quantity available. Search activity is costly. It uses
time and other resources, such as phone calls, automobiles, and gasoline that could have been used in
other productive ways.
A rent ceiling controls only the rent portion of the
cost of housing. The cost of increased search activity
might end up making the full cost of housing higher
than it would be without a rent ceiling. A Black Market
A rent ceiling also encourages illegal trading in a
black market, an illegal market in which the equilibrium price exceeds the price ceiling. Black markets
occur in rent-controlled housing and many other
markets. For example, scalpers run black markets in
tickets for big sporting events and rock concerts.
When a rent ceiling is in force, frustrated renters
and landlords constantly seek ways of increasing
rents. One common way is for a new tenant to pay a
high price for worthless fittings, such as charging
$2,000 for threadbare drapes. Another is for the tenant to pay an exorbitant price for new locks and
keys—called “key money.”
The level of a black market rent depends on
how tightly the rent ceiling is enforced. With loose 9160335_CH06_p125-148.qxd 6/22/09 8:58 AM Page 127 A Housing Market With a Rent Ceiling enforcement, the black market rent is close to the
unregulated rent. But with strict enforcement, the
black market rent is equal to the maximum price that
a renter is willing to pay.
Figure 6.1 illustrates the effects of a rent ceiling.
The demand for housing is D and the supply is S. A
rent ceiling is imposed at $800 a month. Rents that
exceed $800 a month are in the gray-shaded illegal
region in the figure. You can see that the equilibrium
rent, where the demand and supply curves intersect,
is in the illegal region.
At a rent of $800 a month, the quantity of housing
supplied is 60,000 units and the quantity demanded
is 100,000 units. So with a rent of $800 a month,
there is a shortage of 40,000 units of housing.
To rent the 60,000th unit, someone is willing to
pay $1,200 a month. They might pay this amount by
incurring search costs that bring the total cost of
housing to $1,200 a month, or they might pay a
black market price of $1,200 a month. Either way,
they end up incurring a cost that exceeds what the
equilibrium rent would be in an unregulated market. Inefficiency of a Rent Ceiling
A rent ceiling set below the equilibrium rent results
in an inefficient underproduction of housing services. The marginal social benefit of housing exceeds
its marginal social cost and a deadweight loss shrinks
the producer surplus and consumer surplus
(Chapter 5, pp. 111–112).
Figure 6.2 shows this inefficiency. The rent ceiling
($800 per month) is below the equilibrium rent
($1,000 per month) and the quantity of housing supplied (60,000 units) is less than the efficient quantity
Because the quantity of housing supplied (the quantity available) is less than the efficient quantity, there is
a deadweight loss, shown by the gray triangle. Producer
surplus shrinks to the blue triangle and consumer surplus shrinks to the green triangle. The red rectangle
represents the potential loss from increased search activity. This loss is borne by consumers and the full loss
from the rent ceiling is the sum of the deadweight loss
and the increased cost of search.
The Inefficiency of a Rent Ceiling Rent (dollars per unit per month) A Rent Ceiling
market rent 1,200 S
shortage Rent (dollars per unit per month) F IGURE 6.2
F IGURE 6.1 1,400 1,200 D 80 60 100 120 Quantity (thousands of units per month) A rent above the rent ceiling of $800 a month is illegal (in
the gray-shaded illegal region). At a rent of $800 a month,
the quantity of housing supplied is 60,000 units. Frustrated
renters spend time searching for housing and they make
deals with landlords in a black market. Someone is willing
to pay $1,200 a month for the 60,000th unit.
animation S Deadweight
ceiling 800 0
search 1,000 600 600 127 Producer
surplus D 60 80 100 120 Quantity (thousands of units per month) Without a rent ceiling, the market produces an efficient
80,000 units of housing at a rent of $1,000 a month. A
rent ceiling of $800 a month decreases the quantity of
housing supplied to 60,000 units. Producer surplus and
consumer surplus shrink and a deadweight loss arises. The
red rectangle represents the cost of resources used in
increased search activity. The full loss from the rent ceiling
equals the sum of the red rectangle and gray triangle.
animation 9160335_CH06_p125-148.qxd 128 6/22/09 8:58 AM Page 128 CHAPTER 6 Government Actions in Markets Are Rent Ceilings Fair?
Rent ceilings might be inefficient, but don’t they
achieve a fairer allocation of scarce housing? Let’s
explore this question.
Chapter 5 (pp. 114–117) reviews two key ideas
about fairness. According to the fair rules view, anything that blocks voluntary exchange is unfair, so
rent ceilings are unfair. But according to the fair
result view, a fair outcome is one that benefits the
less well off. So according to this view, the fairest
outcome is the one that allocates scarce housing to
the poorest. To see whether rent ceilings help to
achieve a fairer outcome in this sense, we need to
consider how the market allocates scarce housing
resources in the face of a rent ceiling.
Blocking rent adjustments doesn’t eliminate
scarcity. Rather, because it decreases the quantity of
housing available, it creates an even bigger challenge
for the housing market. Somehow, the market must
ration a smaller quantity of housing and allocate that
housing among the people who demand it.
When the rent is not permitted to allocate scarce
housing, what other mechanisms are available, and
are they fair? Some possible mechanisms are
■ A lottery
Discrimination A lottery allocates housing to those who are lucky,
not to those who are poor. First-come, first-served (a
method used to allocate housing in England after
World War II) allocates housing to those who have
the greatest foresight and who get their names on a
list first, not to the poorest. Discrimination allocates
scarce housing based on the views and self-interest of
the owner of the housing. In the case of public housing, it is the self-interest of the bureaucracy that
administers the allocation that counts.
In principle, self-interested owners and bureaucrats
could allocate housing to satisfy some criterion of fairness, but they are not likely to do so. Discrimination
based on friendship, family ties, and criteria such as
race, ethnicity, or sex is more likely to enter the equation. We might make such discrimination illegal, but
we cannot prevent it from occurring.
It is hard, then, to make a case for rent ceilings on
the basis of fairness. When rent adjustments are
blocked, other methods of allocating scarce housing
resources operate that do not produce a fair outcome. Rent Ceilings in Practice
The Rich and the Famous Win
New York, San Francisco, London, and Paris, four of
the world’s great cities, have rent ceilings in some part
of their housing markets. Boston had rent ceilings for
many years but abolished them in 1997. Many other
U.S. cities do not have, and have never had, rent ceilings. Among them are Atlanta, Baltimore, Chicago,
Dallas, Philadelphia, Phoenix, and Seattle.
To see the effects of rent ceilings in practice we can
compare the housing markets in cities with ceilings
with those without ceilings. We learn two main lessons from such a comparison.
First, rent ceilings definitely create a housing shortage. Second, they do lower the rents for some but raise
them for others.
A survey* conducted in 1997 showed that the rents
of housing units actually available for rent were 2.5
times the average of all rents in New York, but equal to
the average rent in Philadelphia. The winners from rent
ceilings are the families that have lived in a city for a
long time. In New York, these families include some
rich and famous ones. The voting power of the winners
keeps the rent ceilings in place. Mobile newcomers are
the losers in a city with rent ceilings.
The bottom line is that in principle and in practice,
rent ceilings are inefficient and unfair.
* William Tucker, “How Rent Control Drives Out Affordable
Housing.” Review Quiz ◆
4 What is a rent ceiling and what are its effects if
it is set above the equilibrium rent?
What are the effects of a rent ceiling that is set
below the equilibrium rent?
How are scarce housing resources allocated
when a rent ceiling is in place?
Why does a rent ceiling create an inefficient
and unfair outcome in the housing market?
Work Study Plan 6.1
and get instant feedback. You now know how a price ceiling (rent ceiling)
works. Next, we’ll learn about the effects of a price
floor by studying a minimum wage in a labor market. 9160335_CH06_p125-148.qxd 6/22/09 8:58 AM Page 129 A Labor Market With a Minimum Wage Minimum Wage
For each one of us, the labor market is the market
that influences the jobs we get and the wages we
earn. Firms decide how much labor to demand, and
the lower the wage rate, the greater is the quantity
of labor demanded. Households decide how much
labor to supply, and the higher the wage rate, the
greater is the quantity of labor supplied. The wage
rate adjusts to make the quantity of labor demanded
equal to the quantity supplied.
When wage rates are low, or when they fail to keep
up with rising prices, labor unions might turn to governments and lobby for a higher wage rate.
A government imposed regulation that makes it
illegal to charge a price lower than a specified level is
called a price floor.
The effects of a price floor on a market depend
crucially on whether the floor is imposed at a level
that is above or below the equilibrium price.
A price floor set below the equilibrium price has no
effect. The reason is that the price floor does not
constrain the market forces. The force of the law and
the market forces are not in conflict. But a price
floor above the equilibrium price has powerful effects
on a market. The reason is that the price floor
attempts to prevent the price from regulating the
quantities demanded and supplied. The force of the
law and the market forces are in conflict.
When a price floor is applied to a labor market, it is
called a minimum wage. A minimum wage imposed at a
level that is above the equilibrium wage creates unemployment. Let’s look at the effects of a minimum wage. Minimum Wage Brings Unemployment
At the equilibrium price, the quantity demanded
equals the quantity supplied. In a labor market,
when the wage rate is at the equilibrium level, the
quantity of labor supplied equals the quantity of
labor demanded: There is neither a shortage of labor
nor a surplus of labor.
But at a wage rate above the equilibrium wage, the
quantity of labor supplied exceeds the quantity of
labor demanded—there is a surplus of labor. So when
a minimum wage is set above the equilibrium wage,
there is a surplus of labor. The demand for labor
determines the level of employment, and the surplus
of labor is unemployed. FIGURE 6.3
Wage rate (dollars per hour) ◆ A Labor Market With a 8 Minimum Wage and
Unemployment 7 129 A S B Minimum
wage 6 Illegal
region 5 D
0 20 21
Quantity (millions of hours per year) The minimum wage rate is set at $7 an hour. Any wage
rate below $7 an hour is illegal (in the gray-shaded illegal
region). At the minimum wage of $7 an hour, 20 million
hours are hired but 22 million hours are available. Unemployment—AB—of 2 million hours a year is created. With
only 20 million hours demanded, someone is willing to supply the 20 millionth hour for $5.
animation Figure 6.3 illustrates the effect of the minimum
wage on unemployment. The demand for labor is D
and the supply of labor is S. The horizontal red line
shows the minimum wage set at $7 an hour. A wage
rate below this level is illegal, in the gray-shaded illegal region of the figure. At the minimum wage rate,
20 million hours of labor are demanded (point A)
and 22 million hours of labor are supplied (point B),
so 2 million hours of available labor are unemployed.
With only 20 million hours demanded, someone
is willing to supply that 20 millionth hour for $5.
Frustrated unemployed workers spend time and other
resources searching for hard-to-find jobs. Inefficiency of a Minimum Wage
In the labor market, the supply curve measures the
marginal social cost of labor to workers. This cost is
leisure forgone. The demand curve measures the
marginal social benefit from labor. This benefit is 9160335_CH06_p125-148.qxd 6/22/09 8:58 AM Page 130 CHAPTER 6 Government Actions in Markets 130 the value of the goods and services produced. An
unregulated labor market allocates the economy’s
scarce labor resources to the jobs in which they are
valued most highly. The market is efficient.
The minimum wage frustrates the market mechanism and results in unemployment and increased job
search. At the quantity of labor employed, the marginal social benefit of labor exceeds its marginal social
cost and a deadweight loss shrinks the firms’ surplus
and the workers’ surplus.
Figure 6.4 shows this inefficiency. The minimum
wage ($7 an hour) is above the equilibrium wage ($6
an hour) and the quantity of labor demanded and
employed (20 million hours) is less than the efficient
quantity (21 million hours).
Because the quantity of labor employed is less than
the efficient quantity, there is a deadweight loss, shown
by the gray triangle. The firms’ surplus shrinks to the
blue triangle and the workers’ surplus shrinks to the
green triangle. The red rectangle shows the potential
loss from increased job search, which is borne by
workers. The full loss from the minimum wage is the
sum of the deadweight loss and the increased cost of
The Inefficiency of a
Minimum Wage Wage rate (dollars per hour) FIGURE 6.4 9 Firms'
job search 8
loss 0 D Workers'
surplus 19 20 21
Quantity (millions of hours per year) A minimum wage decreases employment. Firms’ surplus (blue
area) and workers’ surplus (green area) shrink and a deadweight loss (gray area) arises. Job search increases and the
red area shows the loss from this activity.
animation In the United States, the federal government’s Fair
Labor Standards Act sets the minimum wage, which
has fluctuated between 35 percent and 50 percent of
the average wage, and in 2009 was $7.25 an hour.
Most states have minimum wages that exceed the
Does the minimum wage result in unemployment,
and if so, how much unemployment does it create?
The consensus answer is that a 10 percent rise in the
minimum wage decreases teenage employment by
between 1 and 3 percent.
This consensus answer has been challenged by
David Card of the University of California at
Card and Krueger say that increases in the minimum wage have increased teenage employment and
From their study of minimum wages in California,
New Jersey, and Texas, Card and Krueger say that the
employment rate of low-income workers increased following an increase in the minimum wage. They argue
that a higher wage increases employment by making
workers become more conscientious and productive Is the Minimum Wage Fair? 6 3 Unscrambling Cause and Effect S Minimum
wage 4 The Minimum Wage in Practice The minimum wage is unfair on both views of fairness: It delivers an unfair result and imposes an
The result is unfair because only those people who
have jobs and keep them benefit from the minimum
wage. The unemployed end up worse off than they
would be with no minimum wage. Some of those
who search for jobs and find them end up worse off
because of the increased cost of job search they incur.
Also those who find jobs aren’t always the least well
off. When the wage rate doesn’t allocate labor, other
mechanisms determine who finds a job. One such
mechanism is discrimination, which is yet another
source of unfairness.
The minimum wage imposes an unfair rule
because it blocks voluntary exchange. Firms are willing to hire more labor and people are willing to work
more, but they are not permitted by the minimum
wage law to do so. 9160335_CH06_p125-148.qxd 6/22/09 8:58 AM Page 131 Taxes and less likely to quit, which lowers unproductive labor
turnover. They also argue that a higher wage rate makes
managers seek ways to increase labor productivity.
Most economists are skeptical about Card and
Krueger’s argument. Why, economists ask, don’t firms
freely pay wage rates above the equilibrium wage to
encourage more productive work habits? Also, they
point to other explanations for the employment
responses that Card and Krueger found.
According to Daniel Hamermesh of the University
of Texas at Austin, Card and Krueger got the timing
wrong. Hamermesh says that firms cut employment
before the minimum wage is increased in anticipation
of the increase. If he is correct, looking for the effects
of an increase after it has occurred misses its main
Finis Welch of Texas A&M University and Kevin
Murphy of the University of Chicago say the employment effects that Card and Krueger found are caused
by regional differences in economic growth, not by
changes in the minimum wage.
One effect of the minimum wage is an increase in
the quantity of labor supplied. If this effect occurs, it
might show up as an increase in the number of people who quit school to look for work before completing high school. Some economists say that this
response does occur. Review Quiz ◆
5 What is a minimum wage and what are its
effects if it is set above the equilibrium wage?
What are the effects of a minimum wage set
below the equilibrium wage?
Explain how scarce jobs are allocated when a
minimum wage is in place.
Explain why a minimum wage creates an inefficient allocation of labor resources.
Explain why a minimum wage is unfair.
Work Study Plan 6.2
and get instant feedback. Next we’re going to study a more widespread government action in markets: taxes. We’ll see how taxes
change prices and quantities. You will discover the
surprising fact that while the government can impose
a tax, it can’t decide who will pay the tax! And you
will see that a tax creates a deadweight loss. 131 ◆ Taxes
Everything you earn and almost everything you buy
is taxed. Income taxes and Social Security taxes are
deducted from your earnings and sales taxes are
added to the bill when you buy something.
Employers also pay a Social Security tax for their
workers, and producers of tobacco products, alcoholic drinks, and gasoline pay a tax every time they
Who really pays these taxes? Because the income
tax and Social Security tax are deducted from your
pay, and the sales tax is added to the prices that you
pay, isn’t it obvious that you pay these taxes? And isn’t
it equally obvious that your employer pays the
employer’s contribution to the Social Security tax and
that tobacco producers pay the tax on cigarettes?
You’re going to discover that it isn’t obvious who
really pays a tax and that lawmakers don’t make that
decision. We begin with a definition of tax incidence. Tax Incidence
is the division of the burden of a tax
between buyers and sellers. When the government
imposes a tax on the sale of a good*, the price paid by
buyers might rise by the full amount of the tax, by a
lesser amount, or not at all. If the price paid by buyers rises by the full amount of the tax, then the burden of the tax falls entirely on buyers—the buyers
pay the tax. If the price paid by buyers rises by a
lesser amount than the tax, then the burden of the
tax falls partly on buyers and partly on sellers. And if
the price paid by buyers doesn’t change at all, then
the burden of the tax falls entirely on sellers.
Tax incidence does not depend on the tax law. The
law might impose a tax on sellers or on buyers, but
the outcome is the same in either case. To see why,
let’s look at the tax on cigarettes in New York City.
Tax incidence A Tax on Sellers
On July 1, 2002, Mayor Bloomberg put a tax of
$1.50 a pack on cigarettes sold in New York City.
To work out the effects of this tax on the sellers of
cigarettes, we begin by examining the effects on
demand and supply in the market for cigarettes. * These propositions also apply to services and factors of production (land, labor, capital). 9160335_CH06_p125-148.qxd 8:58 AM Page 132 CHAPTER 6 Government Actions in Markets In Fig. 6.5, the demand curve is D, and the supply
curve is S. With no tax, the equilibrium price is $3 per
pack and 350 million packs a year are bought and sold.
A tax on sellers is like an increase in cost, 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. You can see that without the tax,
sellers are willing to offer 350 million packs a year
for $3 a pack. So with a $1.50 tax, they will offer
350 million packs a year only if the price is $4.50 a
pack. The supply curve shifts to the red curve
labeled S + tax on sellers.
Equilibrium occurs where the new supply curve
intersects the demand curve at 325 million packs a
year. The price paid by buyers rises by $1 to $4 a
pack. And the price received by sellers falls by 50¢ to
$2.50 a pack. So buyers pay $1 of the tax and sellers
pay the other 50¢. A Tax on Buyers
Suppose that instead of taxing sellers, New York
City taxes cigarette buyers $1.50 a pack.
A tax on buyers lowers the amount they are willing to pay sellers, so it decreases demand and shifts
the demand curve leftward. To determine the position of this new demand curve, we subtract the tax
from the maximum price that buyers are willing to
pay for each quantity bought. You can see, in Fig.
6.6, that without the tax, buyers are willing to buy
350 million packs a year for $3 a pack. So with a
$1.50 tax, they are willing to buy 350 million
packs a year only if the price including the tax is $3
a pack, which means that they’re willing to pay sellers only $1.50 a pack. The demand curve shifts to
become the red curve labeled D – tax on buyers.
Equilibrium occurs where the new demand curve
intersects the supply curve at a quantity of 325 million packs a year. The price received by sellers is
$2.50 a pack, and the price paid by buyers is $4. Equivalence of Tax on Buyers and Sellers
You can see that the tax on buyers in Fig. 6.6 has
the same effects as the tax on sellers in Fig. 6.5. In
both cases, the equilibrium quantity decreases to
325 million packs a year, the price paid by buyers
rises to $4 a pack, and the price received by sellers
falls to $2.50 a pack. Buyers pay $1 of the $1.50
tax, and sellers pay the other 50¢ of the tax. A Tax on Sellers FIGURE 6.5
Price (dollars per pack) 132 6/22/09 5.00 S + tax on sellers Price paid
by buyers S 4.50 $1.50 tax 4.00 3.00
2.50 Price with no tax 2.00 1.00 Price received
by sellers D
0 275 300 325 350 375 400 425 450
Quantity (millions of packs per year) With no tax, 350 million packs a year are bought and sold at
$3 a pack. A tax on sellers of $1.50 a pack shifts the supply
curve leftward to S + tax on sellers. The equilibrium quantity
decreases to 325 million packs a year, the price paid by buyers rises to $4 a pack, and the price received by sellers falls
to $2.50 a pack. The tax raises the price paid by buyers by
less than the tax and lowers the price received by sellers, so
buyers and sellers share the burden of the tax.
animation Can We Share the Burden Equally? Suppose that Mayor Bloomberg wants the burden of the cigarette
tax to fall equally on buyers and sellers and declares
that a 75¢ tax be imposed on each. Is the burden of
the tax then shared equally?
You can see that it is not. The tax is still $1.50 a
pack. And you’ve seen that the tax has the same effect
regardless of whether it is imposed on sellers or buyers. So imposing half the tax on one and half on the
other is like an average of the two cases you’ve examined. (Draw the demand-supply graph and work out
what happens in this case. The demand curve shifts
downward by 75¢ and the supply curve shifts upward
by 75¢. The new equilibrium quantity is still 325
million packs a year. Buyers pay $4 a pack, of which
75¢ is tax. Sellers receive from buyers $3.25, but
must pay a 75¢ tax, so sellers net $2.50 a pack.)
When a transaction is taxed, there are two prices:
the price paid by buyers, which includes the tax; and
the price received by sellers, which excludes the tax. 9160335_CH06_p125-148.qxd 6/22/09 8:58 AM Page 133 Taxes A Tax on Buyers Price (dollars per pack) FIGURE 6.6 133 Tax Incidence and Elasticity of Demand
The division of the tax between buyers and sellers
depends in part on the elasticity of demand. There
are two extreme cases: 5.00 Price paid
by buyers ■ S
2.50 Perfectly Inelastic Demand Figure 6.7 shows the
Price with no tax $1.50 tax 2.00
1.00 0 ■ Perfectly inelastic demand—buyers pay.
Perfectly elastic demand—sellers pay. Price received
by sellers D
D – tax on buyers 250 275 300 325 350 375 400 425
Quantity (millions of packs per year) With no tax, 350 million packs a year are bought and sold at
$3 a pack. A tax on buyers of $1.50 a pack shifts the
demand curve leftward to D – tax on buyers. The equilibrium
quantity decreases to 325 million packs a year, the price paid
by buyers rises to $4 a pack, and the price received by sellers
falls to $2.50 a pack. The tax raises the price paid by buyers
by less than the tax and lowers the price received by sellers,
so buyers and sellers share the burden of the tax. market for insulin, a vital daily medication for those
with diabetes. Demand is perfectly inelastic at
100,000 doses a day, regardless of the price, as shown
by the vertical demand curve D. That is, a diabetic
would sacrifice all other goods and services rather
than not consume the insulin dose that provides
good health. The supply curve of insulin is S. With
no tax, the price is $2 a dose and the quantity is
100,000 doses a day.
If insulin is taxed at 20¢ a dose, we must add the
tax to the minimum price at which drug companies
are willing to sell insulin. The result is the new supply
curve S + tax. The price rises to $2.20 a dose, but the
quantity does not change. Buyers pay the entire tax
of 20¢ a dose.
F IGURE 6.7 Buyers respond to the price that includes the tax and
sellers respond to the price that excludes the tax.
A tax is like a wedge between the price buyers pay
and the price sellers receive. The size of the wedge
determines the effects of the tax, not the side of the
market on which the government imposes the tax. Price (dollars per dose) animation Tax with Perfectly Inelastic
S + tax 2.20 S Buyers pay
entire tax 2.00 The Social Security Tax The Social Security tax is an example of a tax that Congress imposes equally on
both buyers and sellers. But the principles you’ve just
learned apply to this tax too. The market for labor,
not Congress, decides how the burden of the Social
Security tax is divided between firms and workers.
In the New York City cigarette tax example, buyers
bear twice the burden of the tax borne by sellers. In
special cases, either buyers or sellers bear the entire
burden. The division of the burden of a tax between
buyers and sellers depends on the elasticities of
demand and supply, as you will now see. D
Quantity (thousands of doses per day) In this market for insulin, demand is perfectly inelastic. With
no tax, the price is $2 a dose and the quantity is 100,000
doses a day. A tax of 20¢ a dose shifts the supply curve to
S + tax. The price rises to $2.20 a dose, but the quantity
bought does not change. Buyers pay the entire tax.
animation 9160335_CH06_p125-148.qxd 6/22/09 8:58 AM Page 134 CHAPTER 6 Government Actions in Markets 134 Perfectly Elastic Demand Figure 6.8 shows the market for pink marker pens. Demand is perfectly elastic
at $1 a pen, as shown by the horizontal demand
curve D. If pink pens are less expensive than the
other colors, everyone uses pink. If pink pens are
more expensive than other colors, no one uses pink.
The supply curve is S. With no tax, the price of a
pink pen is $1 and the quantity is 4,000 pens a week.
Suppose that the government imposes a tax of
10¢ a pen on pink marker pens but not on other
colors. The new supply curve is S + tax. The price
remains at $1 a pen, and the quantity decreases to
1,000 pink pens a week. The 10¢ tax leaves the
price paid by buyers unchanged but lowers the
amount received by sellers by the full amount of the
tax. Sellers pay the entire tax of 10¢ a pink pen.
We’ve seen that when demand is perfectly inelastic, buyers pay the entire tax and when demand
is perfectly elastic, sellers pay the entire tax. In the
usual case, demand is neither perfectly inelastic nor
perfectly elastic and the tax is split between buyers
and sellers. But the division depends on the elasticity
of demand: The more inelastic the demand, the
larger is the amount of the tax paid by buyers. Price (dollars per pen) FIGURE 6.8 Tax with Perfectly Elastic Demand
S + tax 1.00 0.90 0 S
Quantity (thousands of marker pens per week) In this market for pink pens, demand is perfectly elastic.
With no tax, the price of a pen is $1 and the quantity is
4,000 pens a week. A tax of 10¢ a pink pen shifts the supply curve to S + tax. The price remains at $1 a pen, and
the quantity of pink pens sold decreases to 1,000 a week.
Sellers pay the entire tax.
animation Tax Incidence and Elasticity of Supply
The division of the tax between buyers and sellers
also depends, in part, on the elasticity of supply.
Again, there are two extreme cases:
■ Perfectly inelastic supply—sellers pay.
Perfectly elastic supply—buyers pay. Perfectly Inelastic Supply Figure 6.9(a) shows the market for water from a mineral spring that flows at a
constant rate that can’t be controlled. Supply is perfectly inelastic at 100,000 bottles a week, as shown by
the supply curve S. The demand curve for the water
from this spring is D. With no tax, the price is 50¢
and the quantity is 100,000 bottles.
Suppose this spring water is taxed at 5¢ a bottle.
The supply curve does not change because the spring
owners still produce 100,000 bottles a week, even
though the price they receive falls. But buyers are
willing to buy the 100,000 bottles only if the price is
50¢ a bottle, so the price remains at 50¢ a bottle. The
tax reduces the price received by sellers to 45¢ a bottle, and sellers pay the entire tax.
Perfectly Elastic Supply Figure 6.9(b) shows the
market for sand from which computer-chip makers
extract silicon. Supply of this sand is perfectly elastic at a price of 10¢ a pound, as shown by the supply curve S. The demand curve for sand is D. With
no tax, the price is 10¢ a pound and 5,000 pounds
a week are bought.
If this sand is taxed at 1¢ a pound, we must add
the tax to the minimum supply-price. Sellers are now
willing to offer any quantity at 11¢ a pound along
the curve S + tax. A new equilibrium is determined
where the new supply curve intersects the demand
curve: at a price of 11¢ a pound and a quantity of
3,000 pounds a week. The tax has increased the price
buyers pay by the full amount of the tax—1¢ a
pound—and has decreased the quantity sold. Buyers
pay the entire tax.
We’ve seen that when supply is perfectly inelastic,
sellers pay the entire tax, and when supply is perfectly
elastic, buyers pay the entire tax. In the usual case,
supply is neither perfectly inelastic nor perfectly elastic and the tax is split between buyers and sellers. But
how the tax is split depends on the elasticity of supply: The more elastic the supply, the larger is the
amount of the tax paid by buyers. 9160335_CH06_p125-148.qxd 6/22/09 8:58 AM Page 135 Taxes Tax and the Elasticity of Supply
S 50 Sellers pay
entire tax 45 D
Quantity (thousands of bottles per week) Price (cents per pound) (a) Perfectly inelastic supply Taxes and Efficiency
A tax drives a wedge between the buying price and the
selling price and results in inefficient underproduction. The price buyers pay is also the buyers’ willingness to pay, which measures marginal social benefit.
The price sellers receive is also the sellers’ minimum
supply-price, which equals marginal social cost.
A tax makes marginal social benefit exceed marginal social cost, shrinks the producer surplus and
consumer surplus, and creates a deadweight loss.
Figure 6.10 shows the inefficiency of a tax on
MP3 players. The demand curve, D, shows marginal
social benefit, and the supply curve, S, shows marginal social cost. Without a tax, the market produces
the efficient quantity (5,000 players a week).
With a tax, the sellers’ minimum supply-price rises
by the amount of the tax and the supply curve shifts
to S + tax. This supply curve does not show marginal
social cost. The tax component isn’t a social cost of
Taxes and Efficiency FIGURE 6.10
S + tax 11 Buyers pay
entire tax S 10 D
0 Price (dollars per MP3 player) Price (cents per bottle) FIGURE 6.9 135 260 Consumer
surplus S + tax
Quantity (thousands of pounds per week) (b) Perfectly elastic supply Part (a) shows the market for water from a mineral spring.
Supply is perfectly inelastic. With no tax, the price is 50¢ a
bottle. With a tax of 5¢ a bottle, the price remains at 50¢ a
bottle. The number of bottles bought remains the same, but
the price received by sellers decreases to 45¢ a bottle.
Sellers pay the entire tax.
Part (b) shows the market for sand. Supply is perfectly
elastic. With no tax, the price is 10¢ a pound. A tax of 1¢
a pound increases the minimum supply-price to 11¢ a
pound. The supply curve shifts to S + tax. The price increases
to 11¢ a pound. Buyers pay the entire tax.
surplus 150 0 1 D 2
5 6 7 8 9 10
Quantity (thousands of MP3 players per week) With no tax, 5,000 players a week are produced. With a
$20 tax, the buyers’ price rises to $210, the sellers’ price
falls to $190, and the quantity decreases to 4,000 players
a week. Consumer surplus shrinks to the green area, and
the producer surplus shrinks to the blue area. Part of the loss
of consumer surplus and producer surplus goes to the government as tax revenue (the purple area) and part becomes
a deadweight loss (the gray area).
animation 9160335_CH06_p125-148.qxd 136 6/22/09 8:58 AM Page 136 CHAPTER 6 Government Actions in Markets production. It is a transfer of resources to the government. At the new equilibrium quantity (4,000 players a week), both consumer surplus and producer
surplus shrink. Part of each surplus goes to the government in tax revenue—the purple area. And part
becomes a deadweight loss—the gray area.
Only in the extreme cases of perfectly inelastic
demand and perfectly inelastic supply does a tax not
change the quantity bought and sold so that no deadweight loss arises. Taxes in Practice
Workers and Consumers Pay the Most
Because the elasticity of the supply of labor is low and
the elasticity of demand for labor is high, workers pay
most of the personal income taxes and most of the
Social Security taxes. Because the elasticities of demand
for alcohol, tobacco, and gasoline are low and the elasticities of supply are high, the burden of these taxes
(excise taxes) falls more heavily on buyers than on sellers.
Personal income taxes Taxes and Fairness
We’ve examined the incidence and the efficiency of
taxes. But when political leaders debate tax issues, it
is fairness, not incidence and efficiency, that gets the
most attention. Democrats complain that Republican
tax cuts are unfair because they give the benefits of
lower taxes to the rich. Republicans counter that it is
fair that the rich get most of the tax cuts because they
pay most of the taxes. No easy answers are available
to the questions about the fairness of taxes.
Economists have proposed two conflicting principles of fairness to apply to a tax system:
■ The benefits principle
The ability-to-pay principle Social Security taxes
Corporation income taxes
Excise taxes 0
Tax receipts (percentage of total)
U.S. Taxes Source of Data: Budget of the United States Government, Fiscal Year
2009, Historical Tables, Table 2.1 The Benefits Principle The benefits principle is the proposition that people should pay taxes equal to the
benefits they receive from the services provided by
government. This arrangement is fair because it
means that those who benefit most pay the most
taxes. It makes tax payments and the consumption of
government-provided services similar to private consumption expenditures.
The benefits principle can justify high fuel taxes to
pay for freeways, high taxes on alcoholic beverages
and tobacco products to pay for public health-care
services, and high rates of income tax on high
incomes to pay for the benefits from law and order
and from living in a secure environment, from which
the rich might benefit more than the poor.
The Ability-to-Pay Principle The ability-to-pay principle is the proposition that people should pay taxes
according to how easily they can bear the burden of
the tax. A rich person can more easily bear the burden than a poor person can, so the ability-to-pay
principle can reinforce the benefits principle to justify
high rates of income tax on high incomes. Review Quiz ◆
1 2 3
5 How does the elasticity of demand influence
the effect of a tax on the price buyers pay, the
price sellers receive, the quantity bought, the
tax revenue, and the deadweight loss?
How does the elasticity of supply influence the
effect of a tax on the price buyers pay, the price
sellers receive, the quantity bought, the tax revenue, and the deadweight loss?
Why is a tax inefficient?
When would a tax be efficient?
What are the two principles of fairness that are
applied to tax systems?
Work Study Plan 6.3
and get instant feedback. Your next task is to study two other types of government actions in markets: production quotas and
subsidies. These tools are often used to influence the
markets for farm products. 40 9160335_CH06_p125-148.qxd 6/22/09 8:58 AM Page 137 P roduction Quotas and Subsidies ◆ Production Quotas and Subsidies ■
■ Production quotas
Subsidies Production Quotas
In the markets for sugarbeets, tobacco leaf, and cotton (among others), governments have, from time
to time, imposed production quotas. A production
quota is an upper limit to the quantity of a good
that may be produced in a specified period. To discover the effects of a production quota, let’s look at
what a quota does to the market for sugarbeets.
Suppose that the growers of sugarbeets want to
limit total production to get a higher price. They persuade the government to introduce a production
quota on sugarbeets.
The effect of the production quota depends on
whether it is set below or above the equilibrium
quantity. If the government introduced a production
quota above the equilibrium quantity, nothing would
change because sugarbeets growers would already be
producing less than the quota. But a production
quota set below the equilibrium quantity has big
effects, which are
■ A decrease in supply
A rise in price
A decrease in marginal cost
An incentive to cheat and overproduce
Figure 6.11 illustrates these effects. The Effects of a
Production Quota FIGURE 6.11
Price (dollars per ton) An early or late frost, a hot dry summer, and a wet
spring present just a few of the challenges that fill
the lives of farmers with uncertainty and sometimes
with economic hardship. Fluctuations in the
weather bring fluctuations in farm output and
prices and sometimes leave farmers with low
incomes. To help farmers avoid low prices and low
incomes, governments intervene in the markets for
Price floors that work a bit like the minimum
wage that you’ve already studied might be used. But
as you’ve seen, this type of government action creates
a surplus and is inefficient. These same conclusions
apply to the effects of a price floor for farm products.
Governments often use two other methods of
intervention in the markets for farm products: Quota 70 137 Illegal
region 60 S
falls 20 D
decreases 10 0 20 40 60
Quantity (millions of tons per year) With no quota, growers produce 60 million tons a year
and the price is $30 a ton. A production quota of 40 million tons a year restricts total production to that amount. The
quantity produced decreases to 40 million tons a year, the
price rises to $50 a ton, and the farmers’ marginal cost falls
to $20 a ton. Because marginal cost (on the supply curve)
is less than marginal benefit (on the demand curve), a
deadweight loss arises from the underproduction.
animation A Decrease in Supply A production quota on sugar- beets decreases the supply of sugarbeets. Each grower is
assigned a production limit that is less than the amount
that would be produced—and supplied—without the
quota. The total of the growers’ limits equals the quota,
and any production in excess of the quota is illegal.
The quantity supplied becomes the amount permitted by the production quota, and this quantity is fixed.
The supply of sugarbeets becomes perfectly inelastic at
the quantity permitted under the quota.
In Fig. 6.11, with no quota, growers would produce
60 million tons of sugarbeets a year—the market equilibrium quantity. With a production quota set at 40
million tons a year, the gray-shaded area shows the illegal region. As in the case of price ceilings and price
floors, market forces and political forces are in conflict
in this illegal region.
The vertical red line labeled “Quota” becomes the
supply curve of sugarbeets at prices above $20 a ton. 9160335_CH06_p125-148.qxd 138 6/22/09 8:58 AM Page 138 CHAPTER 6 Government Actions in Markets A Rise in Price The production quota raises the price
of sugarbeets. When the government sets a production
quota, it leaves market forces free to determine the
price. Because the quota decreases the supply of sugarbeets, it raises the price. In Fig. 6.11, with no quota,
the price is $30 a ton. With a quota of 40 million
tons, the price rises to $50 a ton.
A Decrease in Marginal Cost The production quota
lowers the marginal cost of growing sugarbeets.
Marginal cost decreases because growers produce less
and stop using the resources with the highest marginal cost. Sugarbeets growers slide down their supply
(and marginal cost) curves. In Fig. 6.11, marginal
cost decreases to $20 a ton.
Inefficiency The production quota results in ineffi- cient underproduction. Marginal social benefit at the
quantity produced is equal to the market price, which
has increased. Marginal social cost at the quantity
produced has decreased and is less than the market
price. So marginal social benefit exceeds marginal
social cost and a deadweight loss arises.
An Incentive to Cheat and Overproduce The pro- duction quota creates an incentive for growers to
cheat and produce more than their individual production limit. With the quota, the price exceeds marginal cost, so the grower can get a larger profit by
producing one more unit. Of course, if all growers
produce more than their assigned limit, the production quota becomes ineffective, and the price falls to
the equilibrium (no quota) price.
To make the production quota effective, growers
must set up a monitoring system to ensure that no
one cheats and overproduces. But it is costly to set up
and operate a monitoring system and it is difficult to
detect and punish producers who violate their quotas.
Because of the difficulty of operating a quota, producers often lobby governments to establish a quota
and provide the monitoring and punishment systems
that make it work. Subsidies
In the United States, the producers of peanuts, sugarbeets, milk, wheat, and many other farm products
receive subsidies. A subsidy is a payment made by
the government to a producer. A large and controversial Farm Bill passed by Congress in 2008
renewed and extended a wide range of subsidies. The effects of a subsidy are similar to the effects
of a tax but they go in the opposite directions.
These effects are
An increase in supply
■ A fall in price and increase in quantity produced
■ An increase in marginal cost
■ Payments by government to farmers
■ Inefficient overproduction
Figure 6.12 illustrates the effects of a subsidy to
■ An Increase in Supply In Fig. 6.12, with no subsidy,
the demand curve D and the supply curve S determine the price of peanuts at $40 a ton and the quantity of peanuts at 40 million tons a year.
Suppose that the government introduces a subsidy
of $20 a ton to peanut farmers. A subsidy is like a
negative tax. A tax is equivalent to an increase in cost,
so a subsidy is equivalent to a decrease in cost. The
subsidy brings an increase in supply.
To determine the position of the new supply
curve, we subtract the subsidy from the farmers’ minimum supply-price. In Fig. 6.12, with no subsidy,
farmers are willing to offer 40 million tons a year at a
price of $40 a ton. With a subsidy of $20 a ton, they
will offer 40 million tons a year if the price is as low
as $20 a ton. The supply curve shifts to the red curve
labeled S – subsidy.
A Fall in Price and Increase in Quantity Produced The subsidy lowers the price of peanuts and increases
the quantity produced. In Fig. 6.12, equilibrium
occurs where the new supply curve intersects the
demand curve at a price of $30 a ton and a quantity
of 60 million tons a year.
An Increase in Marginal Cost The subsidy lowers the price paid by consumers but increases the marginal
cost of producing peanuts. Marginal cost increases
because farmers grow more peanuts, which means
that they must begin to use some resources that are
less ideal for growing peanuts. Peanut farmers slide
up their supply (and marginal cost) curves. In Fig.
6.12, marginal cost increases to $50 a ton.
Payments by Government to Farmers The govern- ment pays a subsidy to peanut farmers on each ton of
peanuts produced. In this example, farmers increase
production to 60 million tons a year and receive a 9160335_CH06_p125-148.qxd 6/22/09 8:58 AM Page 139 Production Quotas and Subsidies Price (dollars per ton) FIGURE 6.12 The Effects of a Subsidy 70
rises S – subsidy 40
20 $20 subsidy
increases 10 0 20 40 Farm Subsidies Today
Rich High-Cost Farmers the Winners S 50 139 D 60
Quantity (millions of tons per year) With no subsidy, farmers produce 40 million tons a year at
$40 a ton. A subsidy of $20 a ton shifts the supply curve
rightward to S – subsidy. The equilibrium quantity increases
to 60 million tons a year, the price falls to $30 a ton, and
the price plus the subsidy received by farmers rises to $50 a
ton. In the new equilibrium, marginal cost (on the supply
curve) exceeds marginal benefit (on the demand curve) and
the subsidy results in inefficient overproduction.
animation subsidy of $20 a ton. So peanut farmers receive payments from the government that total $1,200 million
a year. Farm subsidies are a major obstacle to achieving an
efficient use of resources in the global markets for
farm products and are a source of tension between
the United States, Europe, and developing nations.
The United States and the European Union are the
world’s two largest and richest economies. They also
pay their farmers the biggest subsidies, which create
inefficient overproduction of food in these rich
At the same time, U.S. and European subsidies
make it more difficult for farmers in the developing
nations of Africa, Asia, and Central and South America
to compete in global food markets. Farmers in these
countries can often produce at a lower opportunity cost
than the U.S. and European farmers.
Two rich countries, Australia and New Zealand,
have stopped subsidizing farmers. The result has been
an improvement in the efficiency of farming in these
countries. New Zealand is so efficient at producing
lamb and dairy products that it has been called the
Saudi Arabia of milk (an analogy with Saudi Arabia’s
huge oil reserve and production.)
International opposition to U.S. and European
farm subsidies is strong. Opposition to farm subsidies
inside the United States and Europe is growing, but it
isn’t as strong as the pro-farm lobby, so don’t expect an
early end to these subsidies. Review Quiz ◆
1 Inefficient Overproduction The subsidy results in inefficient overproduction. At the quantity produced
with the subsidy, marginal social benefit is equal to
the market price, which has fallen. Marginal social
cost has increased and it exceeds the market price.
Because marginal social cost exceeds marginal social
benefit, the increased production brings inefficiency.
Subsidies spill over to the rest of the world.
Because a subsidy lowers the domestic market price,
subsidized farmers will offer some of their output for
sale on the world market. The increase in supply on
the world market lowers the price in the rest of the
world. Faced with lower prices, farmers in other
countries decrease production and receive smaller
5 Summarize the effects of a production quota on
the market price and the quantity produced.
Explain why a production quota is inefficient.
Explain why a voluntary production quota is difficult to operate.
Summarize the effects of a subsidy on the market price and the quantity produced.
Explain why a subsidy is inefficient.
Work Study Plan 6.4
and get instant feedback. Governments intervene in some markets by making it illegal to trade in a good. Let’s now see how
these markets work. 9160335_CH06_p125-148.qxd 140 6/22/09 8:58 AM Page 140 CHAPTER 6 Government Actions in Markets ◆ Markets for Illegal Goods
Price The markets for many goods and services are regulated, and buying and selling some goods is illegal.
The best-known examples of such goods are drugs,
such as marijuana, cocaine, ecstasy, and heroin.
Despite the fact that these drugs are illegal, trade
in them is a multibillion-dollar business. This trade
can be understood by using the same economic
model and principles that explain trade in legal
goods. To study the market for illegal goods, we’re
first going to examine the prices and quantities that
would prevail if these goods were not illegal. Next,
we’ll see how prohibition works. Then we’ll see how a
tax might be used to limit the consumption of these
goods. A Market for an Illegal Good FIGURE 6.13 J PB
F PC E H G
D … to
QP A Market for an Illegal Drug
When a good is illegal, the cost of trading in the
good increases. By how much the cost increases and
who bears the cost depend on the penalties for violating the law and the degree to which the law is
enforced. The larger the penalties and the better the
policing, the higher are the costs. Penalties might be
imposed on sellers, buyers, or both.
Penalties on Sellers Drug dealers in the United States face large penalties if their activities are
detected. For example, a marijuana dealer could
pay a $200,000 fine and serve a 15-year prison
term. A heroin dealer could pay a $500,000 fine
and serve a 20-year prison term. These penalties are
part of the cost of supplying illegal drugs, and they
bring a decrease in supply—a leftward shift in the
supply curve. To determine the new supply curve,
we add the cost of breaking the law to the minimum price that drug dealers are willing to accept.
In Fig. 6.13, the cost of breaking the law by selling
drugs (CBL) is added to the minimum price that D – CBL
Quantity A Free Market for a Drug
Figure 6.13 shows the market for a drug. The demand
curve, D, shows that, other things remaining the same,
the lower the price of the drug, the larger is the quantity of the drug demanded. The supply curve, S, shows
that, other things remaining the same, the lower the
price of the drug, the smaller is the quantity supplied.
If the drug were not illegal, the quantity bought and
sold would be QC and the price would be PC. S + CBL Cost per unit
the law … The demand curve for drugs is D, and the supply curve is S. If
drugs are not illegal, the quantity bought and sold is QC at a
price of PC—point E. If selling drugs is illegal, the cost of breaking the law by selling drugs (CBL) is added to the minimum
supply-price and supply decreases to S + CBL. The market
moves to point F. If buying drugs is illegal, the cost of breaking
the law is subtracted from the maximum price that buyers are
willing to pay, and demand decreases to D – CBL. The market
moves to point G. With both buying and selling illegal, the
supply curve and the demand curve shift and the market
moves to point H. The market price remains at PC, but the market price plus the penalty for buying rises—point J—and the
market price minus the penalty for selling falls—point K.
animation dealers will accept and the supply curve shifts leftward to S + CBL. If penalties were imposed only on
sellers, the market equilibrium would move from
point E to point F.
Penalties on Buyers In the United States, it is
illegal to possess drugs such as marijuana, cocaine,
ecstasy, and heroin. Possession of marijuana can
bring a prison term of 1 year, and possession of
heroin can bring a prison term of 2 years. Penalties
fall on buyers, and the cost of breaking the law must
be subtracted from the value of the good to determine the maximum price buyers are willing to pay
for the drugs. Demand decreases, and the demand 9160335_CH06_p125-148.qxd 6/22/09 8:58 AM Page 141 M arkets for Illegal Goods curve shifts leftward. In Fig. 6.13, the demand
curve shifts to D – CBL. If penalties were imposed
only on buyers, the market equilibrium would move
from point E to point G.
Penalties on Both Sellers and Buyers If penalties are imposed on both sellers and buyers, both supply and
demand decrease and both the supply curve and the
demand curve shift. In Fig. 6.13, the costs of breaking the law are the same for both buyers and sellers,
so both curves shift leftward by the same amount.
The market equilibrium moves to point H. The market price remains at the competitive market price PC,
but the quantity bought decreases to Q P. Buyers pay
PC plus the cost of breaking the law, which equals PB.
Sellers receive PC minus the cost of breaking the law,
which equals PS.
The larger the penalties and the greater the degree
of law enforcement, the larger is the decrease in
demand and/or supply. If the penalties are heavier on
sellers, the supply curve shifts farther than the
demand curve and the market price rises above PC. If
the penalties are heavier on buyers, the demand curve
shifts farther than the supply curve and the market
price falls below PC. In the United States, the penalties on sellers are larger than those on buyers, so the
quantity of drugs traded decreases and the market
price increases compared with a free market.
With high enough penalties and effective law
enforcement, it is possible to decrease demand and/or
supply to the point at which the quantity bought is zero.
But in reality, such an outcome is unusual. It does not
happen in the United States in the case of illegal drugs.
The key reason is the high cost of law enforcement and
insufficient resources for the police to achieve effective
enforcement. Because of this situation, some people suggest that drugs (and other illegal goods) should be legalized and sold openly but also taxed at a high rate in the
same way that legal drugs such as alcohol are taxed.
How would such an arrangement work? Legalizing and Taxing Drugs
From your study of the effects of taxes, it is easy to see
that the quantity bought of a drug could be decreased if
the drug was legalized and taxed. Imposing a sufficiently high tax could decrease the supply, raise the
price, and achieve the same decrease in the quantity
bought as does a prohibition on drugs. The government would collect a large tax revenue. 141 Illegal Trading to Evade the Tax It is likely that an extremely high tax rate would be needed to cut the
quantity of drugs bought to the level prevailing with
a prohibition. It is also likely that many drug dealers
and consumers would try to cover up their activities
to evade the tax. If they did act in this way, they
would face the cost of breaking the law—the tax law.
If the penalty for tax law violation is as severe and as
effectively policed as drug-dealing laws, the analysis
we’ve already conducted applies also to this case. The
quantity of drugs bought would depend on the
penalties for law breaking and on the way in which
the penalties are assigned to buyers and sellers.
Taxes Versus Prohibition: Some Pros and Cons Which is more effective: prohibition or taxes? In favor
of taxes and against prohibition is the fact that the tax
revenue can be used to make law enforcement more
effective. It can also be used to run a more effective
education campaign against illegal drug use. In favor
of prohibition and against taxes is the fact that prohibition sends a signal that might influence preferences,
decreasing the demand for illegal drugs. Also, some
people intensely dislike the idea of the government
profiting from trade in harmful substances. Review Quiz ◆
1 2 3 4 How does the imposition of a penalty for selling an illegal drug influence demand, supply,
price, and the quantity of the drug consumed?
How does the imposition of a penalty for possessing an illegal drug influence demand, supply,
price, and the quantity of the drug consumed?
How does the imposition of a penalty for selling or possessing an illegal drug influence
demand, supply, price, and the quantity of the
Is there any case for legalizing drugs?
Work Study Plan 6.5
and get instant feedback. ◆ You now know how to use the demand and supply model to predict prices, to study government actions in
markets, and to study the sources and costs of inefficiency. In Reading Between the Lines on pp. 142–143,
you will see how to apply what you’ve learned to the
market for gasoline and see why it is difficult for the
government to lower the price in that market. 9160335_CH06_p125-148.qxd 6/22/09 8:58 AM Page 142 READING BETWEEN THE LINES Government Actions in Gasoline Markets
Drivers, Feeling the Pinch as Diesel Tops $4 a Gallon,
Demand Congressional Action
The Washington Post, April 29, 2008 A caravan of horn-honking truck drivers rolled their rigs through Washington yesterday,
protesting rising gasoline costs and demanding that Congress impose caps on prices at the
pump. The truckers, who formed a long column, circled the Mall about noon and blared
their horns. Some spectators waved while others covered their ears. “The high price for oil is
hurting our economy,” said Mark Kirsch, a trucker from Myerstown, Pa., who helped organize the rally. “It’s hurting middle-class people.” …
Copyright 2008 The Washington Post. Reprinted with permission. Further reproduction prohibited. Obama Assails Lifting of Gas Tax as “Gimmick”
The Boston Globe, April 30, 2008 Barack Obama didn’t back down yesterday in his opposition to a so-called gas tax holiday
this summer. … He told voters in Winston-Salem, N.C., that suspending the 18.4-cents-agallon federal gas tax between Memorial Day and Labor Day would save them only about
$25 to $30. Some economists, he said, believe the proposal could backfire and actually raise
prices by increasing demand. “We don’t know that the oil companies will actually pass on the
savings,” he added.
© 2008 NY Times Company. Citing Oil Prices, Asia Starts Reducing Fuel Subsidies
The New York Times, November 2, 2007 Consumers in Asia are feeling the heat of skyrocketing oil prices … as governments start
rolling back subsidies that have kept costs for gasoline and other fuel artificially low. …
Retail prices of petroleum-based products like gasoline, kerosene, and diesel are highly subsidized in many Asian countries, in part to make them affordable to citizens who earn lower
wages than in the developed world. …
Copyright 2008 The New York Times Company. Reprinted with permission. Further reproduction prohibited. Essence of the Story
■ Truck drivers want Congress to impose a cap on the
price of gasoline to stop high prices from hurting middle-class people. ■ Barack Obama opposed a temporary suspension of
the 18.4-cents-a-gallon federal gas tax because it 142 would save only $25 to $30 and because the tax cut
might not lower the price of gasoline.
■ In some Asian countries, the government subsidizes
gasoline and other petroleum-based products to make
them affordable to low-wage citizens. 6/22/09 8:58 AM Page 143 Price (dollars per gallon) 9160335_CH06_p125-148.qxd Economic Analysis
■ With the price of gasoline passing $4 a gallon, there
is no shortage of demands for government action to
lower the price. ■ Truck drivers want a price cap. ■ But a price cap creates a shortage, which would mean
lines at the pump, wasteful driving around to find a
gas station with gas for sale, and possibly a black market in gasoline. ■ Figure 1 illustrates these consequences of a $3 price
cap in the market for gasoline. The figure shows a
shortage, the possible black market price, and the
deadweight loss created. 0 ■ ■ ■ The problem with a subsidy is similar to that of a tax
cut. It lowers the buyers’ price but it increases the
quantity bought and raises the sellers’ price.
Figure 3 illustrates these consequences of a subsidy.
The figure is calibrated to the market for gasoline in
China, where the price is $1.50 a gallon and quantity bought is a bit more than 1 million barrels per
A subsidy of $1 a gallon lowers the price to $1.50 a
gallon, but sellers receive $2.50 a gallon.
Both a tax cut and a subsidy increase the quantity of
gasoline bought. Because gasoline is produced from
crude oil, these actions increase the demand for crude
oil, which raises its price. 9.0 9.1
Quantity (millions of barrels per day) S + tax
S 6 5 Sellers’
price rises 4 3 Buyers’
price falls D
increases 0 9.0 9.1
Quantity (millions of barrels per day) Figure 2 Summer suspension of the federal gas tax
Price (dollars per gallon) ■ What about an outright subsidy to buyers? That’s what
happens in China, where until mid 2008 when the
price began to rise sharply, a subsidy kept the price of
gas at the equivalent of $1.50 a gallon. Price cap D Figure 1 A price cap on gasoline If supply is almost perfectly inelastic (not the case
shown in the figure) the buyers’ price doesn’t fall at all
and sellers get the entire benefit of the tax cut. This
possibility was raised by Senator Obama in his opposition to the tax suspension. ■ Possible
shortage Figure 2 illustrates these consequences of a tax holiday, and the effect is tiny. ■ 5 Deadweight
loss 3 Another proposal is to suspend the federal gas tax. A
tax cut lowers the price paid by buyers, but it increases
the quantity bought and raises the price received by
sellers. ■ 6 4 Price (dollars per gallon) ■ S + tax 3.50
price rises S S – subsidy 2.50
price falls D
increases 0.50 0 1.06 1.08 1.10 1.12 1.14 1.16
Quantity (millions of barrels per day) Figure 3 Gasoline subsidy in China 143 9160335_CH06_p125-148.qxd 144 6/22/09 8:58 AM Page 144 CHAPTER 6 Government Actions in Markets SUMMARY ◆ Key Points ■ A Housing Market With a Rent Ceiling (pp. 126–128)
■ ■ ■ A rent ceiling that is set above the equilibrium rent
has no effect.
A rent ceiling that is set below the equilibrium
rent creates a housing shortage, increased search
activity, and a black market.
A rent ceiling that is set below the equilibrium
rent is inefficient and unfair. A Labor Market With a Minimum Wage (pp. 129–131)
■ ■ ■ A minimum wage set below the equilibrium wage
rate has no effect.
A minimum wage set above the equilibrium wage
rate creates unemployment and increases the
amount of time people spend searching for a job.
A minimum wage set above the equilibrium wage
rate is inefficient, unfair, and hits low-skilled
young people hardest. ■ Production Quotas and Subsidies (pp. 137–139)
■ ■ ■ ■ Taxes (pp. 131–136) ■ A tax raises the price paid by buyers, but usually
by less than the tax.
The elasticity of demand and the elasticity of supply
determine the share of a tax paid by buyers and sellers. A production quota leads to inefficient underproduction, which raises the price.
A subsidy is like a negative tax. It lowers the price,
increases the cost of production, and leads to inefficient overproduction. Markets for Illegal Goods (pp. 140–141) ■ ■ The less elastic the demand or the more elastic the
supply, the larger is the share of the tax paid by
If demand is perfectly elastic or supply is perfectly
inelastic, sellers pay the entire tax. And if demand
is perfectly inelastic or supply is perfectly elastic,
buyers pay the entire tax. ■ Penalties on sellers increase the cost of selling the
good and decrease the supply of the good.
Penalties on buyers decrease their willingness to
pay and decrease the demand for the good.
Penalties on buyers and sellers decrease the quantity of the good, raise the price buyers pay, and
lower the price sellers receive.
Legalizing and taxing can achieve the same outcome as penalties on buyers and sellers. Key Figures
Figure 6.4 A Rent Ceiling, 127
The Inefficiency of a Rent
Minimum Wage and
The Inefficiency of a Minimum
Wage, 130 Figure 6.5
Figure 6.11 A Tax on Sellers, 132
A Tax on Buyers, 133
Taxes and Efficiency, 135
The Effects of a Production Quota, Figure 6.12
Figure 6.13 The Effects of a Subsidy, 139
A Market for an Illegal Good, 140 137 Key Terms
Black market, 126
Minimum wage, 129
Price cap, 126
Price ceiling, 126 Price floor, 129
Production quota, 137
Rent ceiling, 126
Search activity, 126 Subsidy, 138
Tax incidence, 131 9160335_CH06_p125-148.qxd 6/22/09 8:58 AM Page 145 Problems and Applications PROBLEMS and APPLICATIONS 145 ◆ Work problems 1–10 in Chapter 6 Study Plan and get instant feedback.
Work problems 11–19 as Homework, a Quiz, or a Test if assigned by your instructor. Rent (dollars per month) 1. The graph illustrates the market for rental housing in Townsville.
600 450 300 Wage rate 150 D 0 d. Draw a demand and supply graph to illustrate
the effects of a price ceiling set below the equilibrium price in the market for gasoline.
3. Explain the various ways in which a price ceiling
on gasoline that is set below the equilibrium
price would make buyers and sellers of gasoline
better off or worse off. What would happen to
total surplus and deadweight loss in this market?
4. The table gives the demand and supply schedules
of teenage labor. 10 20 30
Quantity (thousands) a. What are the equilibrium rent and equilibrium
quantity of rental housing?
If a rent ceiling is set at $600 a month, what is
b. The quantity of housing rented?
c. The shortage of housing?
If a rent ceiling is set at $300 a month, what is
d. The quantity of housing rented?
e. The shortage of housing?
f. The maximum price that someone is willing
to pay for the last unit of housing available?
2. Capping Gasoline Prices
The recent rise in gasoline prices has many people calling for price caps. … Price caps are a curse
to consumers. … Capped prices … generate a
distorted reflection of reality, causing buyers and
suppliers to act in ways inconsistent with it. …
By masking reality, price controls only make
Pittsburgh Tribune-Review, September 12, 2005
If a price ceiling is set below the equilibrium
price in the market for gasoline, what are its
a. The quantity of gasoline supplied and the
b. The quantity of gasoline sold and the shortage
or surplus of gasoline?
c. The maximum price that someone is willing
to pay for the last gallon of gasoline available
on a black market? (dollars
per hour) Quantity
d emanded Quantity
supplied (hours per month) 4
a. What are the equilibrium wage rate and number of hours worked?
b. What is the quantity of unemployment?
If a minimum wage for teenagers is set at $5 an
c. How many hours do they work?
d. How many hours of teenage labor are unemployed?
If a minimum wage for teenagers is set at $7 an
e. How many hours do teenagers work and how
many hours are unemployed?
f. Demand for teenage labor increases by 500
hours a month. What is the wage rate paid to
teenagers and how many hours of teenage
labor are unemployed?
5. India Steps Up Pressure for Minimum Wage for
Its Workers in the Gulf
Oil-rich countries in the [Persian] Gulf, already
confronted by strong labor protests, are facing
renewed pressure from India to pay minimum
wages for unskilled workers. The effort by
India—the largest source of migrant workers in
the region, with five million—is the strongest
push yet by home countries to win better conditions for their citizens. …
International Herald Tribune, March 27, 2008 9160335_CH06_p125-148.qxd 8:58 AM Page 146 CHAPTER 6 Government Actions in Markets If the Persian Gulf countries paid a minimum
wage above the equilibrium wage to Indian
a. How would the market for labor be affected in
the Gulf countries? Draw a supply and demand graph to illustrate your answer.
b. How would the market for labor be affected
in India? Draw a supply and demand graph
to illustrate your answer. [Be careful: the
minimum wage is in the Gulf countries, not
c. Would migrant Indian workers be better off
or worse off or unaffected by this minimum
6. The table gives the demand and supply schedules
for chocolate brownies.
demanded John McCain that would shave 18 cents off every
gallon of gas through Labor Day. …
Time, May 19, 2008
If the federal government removed the 18.4 cents
per-gallon gas tax they currently impose,
a. Would the price of gasoline that consumers
pay fall by 18.4 cents? Explain.
b. How would consumer surplus change?
9. The demand and supply schedules for rice are
Price (millions per day) Quantity
supplied (boxes per week) 1.00
a. If brownies are not taxed, what is the price of
a brownie and how many are bought?
b. If sellers are taxed 20¢ a brownie, what are the
price and quantity bought? Who pays the tax?
c. If buyers are taxed 20¢ a brownie, what are
the price and quantity bought? Who pays
7. Luxury Tax Heavier Burden on Working Class,
it would Seem
The Omnibus Budget Reconciliation Act of
1990 … included … a stern tax on “luxury
items.” … In 1990 the Joint Committee on
Taxation projected that the 1991 revenue yield
from the luxury taxes would be $31 million. The
actual yield was $16.6 million. Why? Because
—surprise!—the taxation changed behavior.
The Topeka Capital-Journal, October 29, 1999
a. Would buyers or sellers of “luxury items” pay
more of the luxury tax?
b. Explain why the luxury tax generated far less
tax revenue than was originally anticipated.
8. How to Take a Gas Holiday
High fuel prices will probably keep Americans
closer to home this summer, despite the gas-tax
“holiday” supported by Hillary Clinton and Quantity
per box) 3,500
3,500 What are the price, the marginal cost of producing rice, and the quantity produced if the
a. Sets a production quota for rice of 2,000
boxes a week?
b. Introduces a subsidy to rice growers of $0.30 a
10. The figure illustrates the market for a banned
Price (dollars per unit) 146 6/22/09 S
100 60 20 D
0 70 110 150
Quantity (units) What are the market price and the quantity
consumed if a penalty of $20 a unit is imposed
a. Sellers only?
b. Buyers only?
c. Both sellers and buyers? 9160335_CH06_p125-148.qxd 6/22/09 8:58 AM Page 147 Problems and Applications 11. Coal Shortage at China Plants
Chinese power plants have run short of coal, an
unintended effect of government-mandated price
controls—a throwback to communist central
planning—to shield the public from rising global
energy costs. … Beijing has also frozen retail
prices of gasoline and diesel. That helped farmers
and the urban poor, but it has spurred sales of
gas-guzzling luxury cars and propelled doubledigit annual growth in fuel consumption.
Oil refiners say they are suffering heavy losses
and some began cutting production last year, causing fuel shortages in parts of China ’s south.
CNN, May 20, 2008
a. Are China’s price controls described in the
news clip price floors or price ceilings?
b. Explain how China’s price controls have created shortages or surpluses in the markets for
coal, gasoline, and diesel.
c. Illustrate your answer to b graphically by
using the supply and demand model.
d. Explain how China’s price controls have
changed consumer surplus, producer surplus,
total surplus, and the deadweight loss in the
markets for coal, gasoline, and diesel.
e. Illustrate your answer to d graphically by
using the supply and demand model.
12. Despite Protests, Rent Board Sets 7.25%
Rents for New York City’s one million rentstabilized apartments can increase by as much
as 7.25 percent over the next two years, the
city’s Rent Guidelines Board voted last night.
… According to a report … costs for the owners of rent-stabilized buildings rose by 7.8 percent in the last year. … The rent-increase vote
comes at a time of growing concern about the
ability of the middle class to afford to live in
New York City.
The New York Times, June 28, 2006
a. If rents for rent-stabilized apartments do not
increase, how do you think the market for
rental units in New York City will develop?
b. Are rent ceilings in New York City helpful to
the middle class? Why or why not?
c. Explain the effect of the increase in the rent
ceiling on the quantity of rent-stabilized
d. Why is rent stabilization a source of conflict
between renters and owners of apartments? 147 13. House Passes Increase in Minimum Wage to
… first increase in the federal minimum wage in
nearly a decade, boosting the wages of the lowest-paid American workers from $5.15 to $7.25
an hour. … Republican leaders, backed by smallbusiness lobbyists and restaurant groups, argued
fiercely that raising the minimum wage would
cripple the economy and must be accompanied
by significant tax cuts for small businesses. …
The Washington Post, January 11, 2007
a. Use a graph of the market for low-skilled labor
to illustrate the effect of the increase in the
minimum wage from $5.15 to $7.25 an hour
on the quantity of labor employed.
b. Explain the effects of the higher minimum
wage on the workers’ surplus and the firms’
surplus. Does the labor market become more
efficient or less efficient? Explain.
c. Would a cut in the tax on the small business
profits offset the effect of the higher minimum
wage on employment? Explain.
d. Would a cut in the Social Security tax that
small businesses pay offset the effect of the
higher minimum wage on employment? Explain.
14. The demand and supply schedules for tulips are
per bunch) Quantity
d emanded Quantity
supplied (bunches per week) 10
a. If tulips are not taxed, what is the price and
how many bunches are bought?
b. If tulips are taxed $6 a bunch, what are the
price and quantity bought? Who pays the tax?
15. Congress passes farm bill, defies Bush
Congress sent the White House a huge electionyear farm bill Thursday that includes a boost in
farm subsidies. … Bush has threatened to veto
the $290 billion bill, saying it is fiscally irresponsible and too generous to wealthy corporate
farmers in a time of record crop prices. … $40
billion is for farm subsidies, while almost $30
billion would go to farmers to idle their land. …
CNN, May 15, 2008 9160335_CH06_p125-148.qxd 148 6/22/09 8:58 AM Page 148 CHAPTER 6 Government Actions in Markets a. Why does the federal government subsidize
b. Explain how a subsidy paid to cotton farmers
affects the price of cotton and the marginal
cost of producing it.
c. Explain how a subsidy paid to cotton farmers
affects the consumer surplus and the producer
surplus from cotton. Does the subsidy make
the cotton market more efficient or less efficient? Explain.
d. How would a payment to cotton farmers to
idle their land influence the supply of cotton?
e. How would a payment to cotton farmers to
idle their land affect the consumer surplus
and the producer surplus from cotton?
16. Cigarette Taxes, Black Markets, and Crime:
Lessons from New York’s 50-Year Losing Battle
New York City now has the highest cigarette
taxes in the country—a combined state and
local tax rate of $3.00 per pack. Consumers
have responded by turning to the city's bustling
black market and other low-tax sources of cigarettes. During the four months following the
recent tax hikes, sales of taxed cigarettes in the
city fell by more than 50 percent. … [H]igh
taxes have created a thriving illegal market for
cigarettes in the city. That market has diverted
billions of dollars from legitimate businesses
and governments to criminals. …
Cato Institute, February 6, 2003
a. How has the market for cigarettes in New
York City responded to the high cigarette
b. How does the emergence of a black market
impact the elasticity of demand in a legal
c. Why might an increase in the tax rate actually
cause a decrease in the tax revenue?
17. Study Reading Between the Lines (pp. 142–143)
about the market for gasoline.
a. Explain to truck drivers why a cap on the
price of gasoline would hurt middle class people more than the high price of gasoline hurts.
b. Explain why Barack Obama is right about the
effects of a temporary suspension of the federal gas tax.
c. Explain why it is inefficient for Asian governments to subsidize gasoline. 18. On December 31, 1776, Rhode Island established wage controls to limit wages to 70¢ a day
for carpenters and 42¢ a day for tailors.
a. Are these wage controls a price ceiling or a price
floor? Why might they have been introduced?
b. If these wage controls are effective, would you
expect to see a surplus or a shortage of carpenters and tailors?
19. The table gives the demand and supply schedules
for an illegal drug.
supplied (units per day) 50
a. If there are no penalties on buying or selling
the drug, what is the price and how many
units are consumed?
b. If the penalty on sellers is $20 a unit, what are
the price and quantity consumed?
c. If the penalty on buyers is $20 a unit, what
are the price and quantity consumed?
20. Use the links in MyEconLab (Chapter Resources,
Chapter 6, Web links) to get information about
living wage campaigns and the Harvard Living
a. What is the campaign for a living wage?
b. How would you distinguish the minimum
wage from a living wage?
c. If the Living Wage Campaign succeeds in raising the wage rate above the equilibrium wage
rate, how would the living wage affect the
quantity of labor employed and the amount of
d. Would a living wage set above the equilibrium
wage rate be efficient? Would it be fair?
21. Use the links in MyEconLab (Chapter Resources,
Chapter 6, Web links) to get information about
production quotas on sugar in Europe. Why do
you think the European nations assign production quotas for sugar? If the European sugar quotas are less than the equilibrium quantities, who
benefits from the quotas? Who loses from the
production quotas? ...
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This note was uploaded on 02/07/2010 for the course ECON 251 taught by Professor Blanchard during the Fall '08 term at Purdue.
- Fall '08