Economics 101
Principles of microeconomics
GOVERNMENT ACTIONS IN MARKETS
2 0 1 6 FA L L T E R M
LEC T UR E 5
CHA PT ER 6 – PAG ES 1 2 7 - 1 3 8
Content
Terms defined: efficiency; Externalities; External Cost (or
Negative Externality); External Benefit (or Positive Externality)
Elasticity of Demand and Supply
Explain how rent ceilings create housing shortages and
inefficiency
Explain how minimum wage laws create unemployment and
inefficiency
Explain the effects of a tax – incidence, efficiency, fairness, and
elasticity effects
2
Terms defined
3
Terms
Firm define their MC - Supply Curve
◦ decide whether to produce and sell in market
◦ goal: profit maximization
Consumers define their MB – Demand Curve
◦ decide whether to consume and purchase in
market
◦ goal: maximization of happiness ( utility)
4
Terms
Private vs Social marginal Cost
Private costs to firms or individuals do not always equate with the
total cost to society for a product, service, or activity. The
difference between private costs and total costs to society of a
product, service, or activity is called an external cost.
If External costs > 0 then
5
Terms
Externalities (External Cost) (External Benefits)
 costs (and sometimes benefits) that are not experienced directly by
producers and consumers of goods.
 “spill over” onto third parties.
◦ Negative Externality
◦ Occurs when the individual or firm making a decision does not have
to pay the full cost of the decision.
◦ Ex; processed foods pollution
◦ Positive Externality
◦ Occurs when a benefit for which the agent is not compensated for
in the market price is provided
◦ EX. Unknown caffeine benefits, aesthetics and productivity
Results in misallocation of resources – too much or too little produced it
should be!
6
How does an externality affect the MB and MC curves?
7
Terms
Economic efficiency:
◦ Condition that occurs when all private & external MC and MB
are included in the curves (and decision making)
◦ resources allocated efficiently
◦ Q called the socially optimal output
◦ measured as PS plus CS = ES (largest value)
8
External cost example
Drivers consider private marginal cost when
calculating MC
Drive if MC = MB
External cost of driving – pollution to air
If forced to pay for the health damage of car
exhaust what happens?
MC will increase by the amount of the external
cost.
◦ forced to equate marginal private and
external (social) cost with marginal benefit.
9
External benefit Example
Immunizations
If you get a vaccinations for a certain
disease, it less likely that you will
contract the disease. – private benefit.
External benefit - less likely that other
people will get the disease, because
they probably will not catch it from
you.
10
Terms
Market failure
◦ Conditions that occur when resources are inefficiently
allocated and so too much or too little product is produced.
Deadweight Loss:
• Loss of economic efficiency that can occur when equilibrium
for a good or service is not achieved or is not achievable.
• Measure by ??
11
Elasticity of Demand and Elasticity of
Supply
12
Elasticity Defined
Measure of responsiveness of a
Price change
Qd Elasticity of Demand
Firms want to understand the
relationship between Qd and
Price
◦ If they increase the price what
change will occur in Qd
◦ It will decrease but by how
much
◦ If they decrease price then
what?
Qs Elasticity of Demand
13
14
Rent Ceiling & Housing Market
TEXTBOOK PAGES 128- 130
15
A Housing Market with a Rent Ceiling
◦ price ceiling or price cap
◦ regulation that makes it illegal to charge a price higher than a
specified level.
◦ Ex: rent ceiling in housing market
◦ Why do you think it is regulated?
◦ Set above the equilibrium rent - no effect
◦ Set below equilibrium rent - creates
 A housing shortage
 Increased search activity
 A black market
16
A Housing Market with a Rent Ceiling
◦ Housing Shortage
◦ Figure 6.1 shows the effects
of a rent ceiling that is set
below the equilibrium rent.
◦ The equilibrium rent is
$1,000 a month.
◦ A rent ceiling is set at $800 a
month.
◦ So the equilibrium rent is in
the illegal region.
17
A Housing Market with a Rent Ceiling
◦ At the rent ceiling, the
quantity of housing
demanded exceeds the
quantity supplied.
◦ SHORTAGE!
◦ Is that what was wanted?
18
A Housing Market with a Rent Ceiling
◦ Because the legal price
cannot eliminate the
shortage, other
mechanisms operate:
 Increased search
activity
 A black market
◦ With the shortage,
someone is willing to pay up
to $1,200 a month.
19
A Housing Market with a Rent Ceiling
Increased Search Activity
◦ The time spent looking for
someone with whom to do
business is called search activity.
◦ Shortage results in increased
search activity
◦ costly because
◦ opportunity cost of housing
equals its rent (regulated)
plus the opportunity cost of
the search activity
(unregulated).
20
A Housing Market with a Rent Ceiling
A Black Market
◦ illegal market that operates
alongside a legal market in which a
price ceiling or other restriction
has been imposed.
◦ Illegal arrangements are made
between renters and landlords at
rents above the rent ceiling
21
A Housing Market with a Rent Ceiling
Are Rent Ceilings Inefficient?
◦ A rent ceiling set below the equilibrium rent leads to an
inefficient underproduction of housing services.
◦ The marginal social benefit from housing services exceeds its
marginal social cost and a deadweight loss arises.
22
A Housing Market with a Rent Ceiling
◦ A rent ceiling decreases the
quantity of housing supplied
to less than the efficient
quantity.
◦ A deadweight loss arises.
◦ Producer surplus shrinks.
◦ Consumer surplus shrinks.
◦ There is a potential loss from
increased search activity.
23
A Housing Market with a Rent Ceiling
Are Rent Ceilings Fair?
◦ According to the fair-rules view, a rent ceiling is unfair because
it blocks voluntary exchange.
◦ According to the fair-results view, a rent ceiling is unfair
because it does not generally benefit the poor.
◦ A rent ceiling decreases the quantity of housing and the scarce
housing is allocated by
◦ A lottery gives scarce housing to the lucky.
◦ A first-come, first served gives scarce housing to those who
have the greatest foresight and get their names on the list first.
◦ Discrimination gives scarce housing to friends, family
members, or those of the selected race or sex.
24
Consumer surplus
Producer
surplus
S
STEP 1: BEFORE CEILING
For the supply and
demand curves shown, the
• equilibrium P $14/bbl,
• equilibrium Q 3000
bbl/day.
Calc PS & CS and the ES
D
25
Consumer
surplus
Lost economic surplus
called deadweight loss =
$8000
S
20
Price ($/bbl)
18
Producer
surplus
16
14
12
10
8
D
0
1
2
3
4
5
Price
ceiling
STEP 2: SET THE
CEILING
(government does
this!)
Set a price of 10$ ..
Q supplied goes to
1000 bbl/day
Q demanded is 5000
Too bad consumers
don’t get that!
Recalc PS & CS and
the ES
Quantity (1000’s of bbl/day)
26
Consumer surplus
Lost economic surplus
called deadweight loss
Price ($/bbl)
20
Producer
surplus
S
18
16
14
12
10
8
D
0
1
2
3
4
5
Quantity (1000’s of bbl/day)
Price
ceiling
What is the DWL or
loss of efficiency due
to rent control?
Be sure you
understand the
PS , CS , and DWL
(triangles and
rectangles)
gains? losses?
Economic surplus
loss!
27
Labour Market and Minimum Wage
TEXTBOOK PAGES 130-132
28
A Labour Market with a Minimum
Wage
◦ Price floor
◦ regulation that makes it illegal to trade at a price lower than
a specified level.
◦ Ex: wage in labour market
◦ Set below the equilibrium wage rate - no effect
◦ Set above the equilibrium wage rate, it has powerful effects.
29
A Labour Market with a Minimum
Wage
◦ Minimum Wage Brings Unemployment
◦ Min wage set above the equilibrium wage rate
◦ the quantity of labour supplied by workers exceeds the
quantity demanded by employers.
◦ surplus of labour.
◦ And then unemployment
30
A Labour Market with a Minimum
Wage
◦ The equilibrium wage rate is $9
an hour.
◦ The minimum wage rate is set
at $10 an hour.
◦ So the equilibrium wage rate is
in the illegal region.
31
A Labour Market with a Minimum
Wage
◦ Demanders of labour are the
firms
◦ Suppliers of labour are the
labourers
◦ Q labour supplied > Q labour
demanded
◦ unemployment is created.
◦ With 20 million hours
demanded, some workers are
willing to supply the last hour
demanded for $8.
32
A Labour Market with a Minimum
Wage
Is Minimum Wage Inefficient?
◦leads to an inefficient outcome.
◦ Q labour supplied > Q labour demanded
◦The supply of labour measures the marginal social cost of
labour to workers (leisure forgone).
◦The demand for labour measures the marginal social benefit
from labour (value of goods produced).
33
A Labour Market with a Minimum
Wage
◦ deadweight loss arises.
◦ potential loss from increased
job search decreases both
workers’ surplus and firms’
surplus.
◦ full loss is the sum of the red
and grey areas.
34
A Labour Market with a Minimum
Wage
Is the Minimum Wage Fair?
◦ A minimum wage rate in Canada is set by the provincial
governments.
◦ In 2014, the minimum wage rate ranged from a low of $9.95
an hour in Alberta to a high of $11.00 an hour in Nunavut.
◦ Most economists believe that minimum wage laws increase
the unemployment rate of low-skilled younger workers.
35
Taxes
TEXTBOOK PAGES 132-138
36
Taxes
◦ Everything you earn and most things you buy are taxed.
◦ Who really pays these taxes?
◦ Income taxes and the social security taxes are deducted from
your pay,
◦ HST (or GST) is added to the price of the things you buy
◦ Employer pays the employer’s contribution to the social
security tax
37
Taxes
Tax Incidence (Who Pays)
◦ division of the burden of a tax between buyers and sellers.
◦ When an item is taxed, its price might rise by the full amount
of the tax, by a lesser amount, or not at all.
◦ If the price rises by the full amount of the tax, buyers pay
the tax.
◦ If the price rise by a lesser amount than the tax, buyers and
sellers share the burden of the tax.
◦ If the price doesn’t rise at all, sellers pay the tax.
◦ Tax incidence doesn’t depend on tax law!
38
Review Tax Incidence using tax on
cigarettes in Ontario example
◦ On February 1, 2006, Ontario
raised the tax on the sales of
cigarettes to $3.09 a pack of 25.
◦ What are the effects of this tax?
39
Taxes on Sellers
Tax can be seen as the same as an
increase costs for the producer
(shift intercept of supply curve by
$3)
Taxes
- Intercept shift from P = 2 to P = 5
Result.. shift left of the supply
curve –won’t produce as much Q at
each P because the cost increases..
Note: they don’t get to keep the tax
they collect it and give it to the
gov’t
Equilibrium P = $6 Q= 350
With tax =>
curve S + tax on sellers shows the
new supply curve.
40
Taxes on Sellers
With the tax get a new
P = 8$
Q = 325
How does this affect sellers?
◦ Price they collect is $8 and
then they pay govt the $3 tax
and net out $5 a pack.
◦ receive $1 a pack less.
How does this affect buyers?
◦ Price is the $8
◦ pay $2 a pack more
41
Taxes on Buyers
A Tax on Buyers
◦ Before: equilibrium price is $6 a
pack.
◦ Impose tax on buyers
◦ $3 a pack
◦ Demand decreases and the
curve D  tax on buyers shows
the new demand curve.
42
Taxes on Buyers
◦ Sellers receive:
◦ $5 a pack and the quantity
decreases.
◦ Buyers pay:
◦ $8 a pack.
◦ So with the tax of $3 a pack,
◦ buyers pay $2 a pack more
◦ sellers receive $1 a pack less.
43
Tax Incidence
◦ Tax Incidence results
◦ Tax incidence ( who pays tax) is
the same regardless of whether
the law says sellers pay or buyers
pay.
44
Tax Incidence and Elasticity of
Demand
◦ The division of the tax between buyers and sellers depends on
the elasticities of demand and supply.
45
Tax Incidence and Elasticity of
Demand
Perfectly Elastic demand
 Huge response in Q for P
change
 Ex: Pink Pens
 Tax this product and seller pays
all
46
Tax Incidence and Elasticity of
Demand
Perfectly Elastic Demand
◦ tax is imposed on this
good
◦ sellers pay the entire
tax.
47
Tax Incidence and Elasticity of
Demand
Perfectly Inelastic demand
No response in Q for P change
Consumers do not switch to
substitutes even when price
increases dramatically
 Ex: Insulin
 Tax this product and buyer pays
all
48
Tax Incidence and Elasticity of
Demand
Inelastic Demand
Curve
When a tax is
imposed on this
good, buyers pay
the entire tax
Tax of 20 cents
imposed
49
Tax Incidence and Elasticity of Supply
 Perfectly inelastic supply: Sellers pay the entire tax.
 Perfectly elastic supply: Buyers pay the entire tax.
◦ The more elastic the supply, the larger is the buyers’ share of
the tax.
50
Tax Incidence and Elasticity of Supply
◦ Perfectly Inelastic Supply
◦ The supply of this good is
perfectly inelastic—the
supply curve is vertical.
◦ tax is imposed on this good
◦ sellers pay the entire tax.
51
Tax Incidence and Elasticity of Supply
◦ Perfectly Elastic Supply
◦ supply of this good is perfectly
elastic—the supply curve is
horizontal.
◦ tax is imposed on this good,
buyers pay the entire tax.
52
Taxes in Practice
◦ Taxes usually are levied on goods and services with an inelastic
demand or an inelastic supply.
◦ Alcohol, tobacco, and gasoline have inelastic demand, so the
buyers of these items pay most the tax on them.
◦ Labour has a low elasticity of supply, so the seller—the
worker—pays most of the income tax and most of the social
security tax.
◦ Can you draw these on a curve? And assess the reasons /logic
of each of these?
53
Are Taxes Efficient? How can we
measure?
◦ Except in the extreme cases of perfectly inelastic demand or
perfectly inelastic supply when the quantity remains the same,
imposing a tax creates inefficiency.
◦ Review the economic effect:
- Total Economic Surplus (CS, PS, DWL)
- Change In Total Output
54
Example: The Market for
Potatoes Before Tax: Economic
Surplus, PS and CS
Producer
surplus
(4.5) plus
consumer
surplus
(4.5) =
economic
surplus =
9$
total surplus in
the potato
market equals
the area of the
blue triangle.
$9
million/month.
55
Example: Adding Tax Shifts
Supply Curve
Tax can be seen as
the same as an
increase costs for
the producer
Result.. So a shift left
of the supply curve –
won’t produce as
much Q for each P
as cost increases..
Note: they don’t get
to keep the tax they
collect it and give it
to the gov’t
S + tax
S
3.50
2.50
D
2.5
56
Example: After tax, prices
paid/received and
quantity
supplied/demanded
S + tax
S
Lost Surplus
Also called
deadweight
loss
3.50
2.50
D
2.5
Result from tax … shift SC and
decrease Q to 2.5
Producer: Using SC with Q=2.5
producer receives P = 2.5
Or 3.5 and give the tax to govt.
Consumer: Using DC with Q = 2.5
consumer pays P = 3.5
SO.. THE TAX INCREASE OF 1$
WAS PLACED ON SUPPLIERS BUT
SHARED ½ AND ½
57
At the new Q and P what is the
economic surplus?
PS= ½ X 2.5 X 2.5= 3.13
plus
CS = ½ X 2.5 X 2.5= 3.13
6.25
total surplus in
S + tax
the potato
S equals
market
the area of the
blue triangle.
$6.25
million/month.
6
Price ($/kg)
A $1/kilogram tax on potatoes
would cause an upward shift
in the supply
curve by $1.
Total surplus would shrink to
the area of the pale blue
triangle, $6.25
million/month.
Example: After
Tax, Economic
Surplus, PS and
CS
5
4
3.50
2.50
3
2
1
0
D
1
2 3 4 5
2.5
Quantity (millions of kg/month)
58
So what is the Effect of a $1/
Pound Tax on Potatoes
With tax - At the new Q and P what is the economic surplus?6.25
Without tax - - At the new Q and P what is the economic surplus? 9.00
Net difference= 2.75 million WOW!
But what is missing?
◦ Tax revenue gained – 1$ for 2.5 million Q ( just like the cost of the
government to buy the wheat needs to be accounted for)
Therefore the tax really results in a
◦ gain of 2.5 million in taxes
◦ loss of economic surplus of 2.75 million
◦ netting a reduction of economic surplus or deadweight loss of .25
million.
59
Who bears the burden of
the tax?
Government collects the tax times Q
Tax was collected entirely from potato sellers that was why their SC
increased
Burden fell on buyers and sellers equally
◦ 50cent higher paid by consumer
◦ 50 cent lower received by producer
Note: need not be equally always..
60
Taxes and Fairness
Economists propose two conflicting principles of fairness to
apply to a tax system:
 The benefits principle
 The ability-to-pay principle
61
Taxes and Fairness
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.
62
Taxes and Fairness
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.
63
Production quota and subsidies
TEXTBOOK PAGES 139- 141
64
Production Quotas and Subsidies
◦ Intervention in markets for farm products takes two main
forms:
◦ production quota
◦ upper limit to the quantity of a good that may be produced
during a specified period.
◦ subsidy
◦ payment made by the government to a producer.
65
Production Subsidies and Quotas
◦ no quota, the price is $3 a
tonne and 16 million tonnes a
year are produced.
◦ with quota of 14 million tonnes
a year, quantity decreases to 14
million tonnes a year.
◦ The market price rises to
$5 a tonne and marginal cost
falls to $2 a tonne.
66
Production Quotas and Subsidies
Are quotas inefficient?
◦ At the quantity produced,
◦ marginal social benefit equal
market price, which has
increased.
◦ marginal social cost has
decreased.
◦ Production is inefficient and
producers have an incentive to
cheat.
67
Production Subsidies and Quotas
Subsidies
◦ No subsidy, the price is $40 a
tonne and 40 million tonnes
a year are produced.
◦ With subsidy of $20 a tonne,
marginal cost minus subsidy
falls by $20 a tonne and the
new supply curve is S –
subsidy.
68
Production Subsidies and Quotas
With Subsidy
market price falls to $30 a
tonne and farmers increase the
quantity to
60 million tonnes a year.
◦farmers’ marginal cost
increases to $50 a tonne.
◦farmers receive more on
each tonne produced—the
price of $30 a tonne plus the
subsidy of $20 a tonne, which
is $50 a tonne.
◦Is that why we do this
policy?
69
Production Quotas and Subsidies
Result of subsidy
Inefficient Overproduction
◦ At the quantity produced:
◦ marginal social benefit equals
the market price, which has
fallen.
◦ marginal social cost has
increased and exceeds
marginal social benefit.
70
Production Quotas and Subsidies
So why do we do these?
Efficient?
Fair?
71
Illegal Goods
TEXTBOOK PAGES 142- 143
72
Markets for Illegal Goods
◦ The Canadian government prohibits trade of some goods, such
as illegal drugs.
◦ Yet, markets exist for illegal goods and services.
◦ How does the market for an illegal good work?
◦ To see how the market for an illegal good works, we begin by
looking at a free market and see the changes that occur when
the good is made illegal.
73
Markets for Illegal Goods
A Free Market for a Drug
◦ Figure 6.13 shows the market
for a drug such as marijuana.
◦ Market equilibrium is at point
E.
◦ The price is PC and the
quantity is QC.
74
Markets for Illegal Goods
◦ Penalties on Sellers
◦ If the penalty on the seller is
the amount HK, then the
quantity supplied at a
market price of PC is QP.
◦ Supply of the drug decreases
to S + CBL.
◦ The new equilibrium is at
point F. The price rises and
the quantity decreases.
75
Markets for Illegal Goods
◦ Penalties on Buyers
◦ If the penalty on the buyer is
the amount JH, the quantity
demanded at a market price
of PC is QP.
◦ Demand for the drug
decreases to D – CBL.
◦ The new equilibrium is at
point G. The market price
falls and the quantity
decreases.
76
Markets for Illegal Goods
◦ But the opportunity cost of
buying this illegal good rises
above PC because
◦ the buyer pays the market
price plus the cost of
breaking the law.
77
Markets for Illegal Goods
◦ Penalties on Both Sellers and
Buyers
◦ With both sellers and buyers
penalized for trading in the
illegal drug,
◦ both the demand for the drug
and the supply of the drug
decrease.
78
Markets for Illegal Goods
◦ The new equilibrium is at
point H.
◦ The quantity decreases to
QP.
◦ The market price is PC.
◦ The buyer pays PB and the
seller receives PS.
79
Markets for Illegal Goods
Legalizing and Taxing Drugs
◦ An illegal good can be legalized and taxed.
◦ A high enough tax rate would decrease consumption to the
level that occurs when trade is illegal.
◦ Arguments that extend beyond economics surround this
choice. Such as ??
80
questions
Define and give examples of externalities (+/-)
How does an externality affect the MB and MC curves?
What does efficiency mean to a society? Consumers? Producer?
Define efficiency.
Why does market failure occur? Show on a graph?
What is a private costs? Social cost?
What is socially optimal Q?
How is dead weight loss measured?
How is efficiency defined and measured and shown on a graph?
81
questions
Why is a rent cap regulated? What are the effects on the market?
What is a black market?
Is a rent cap efficient ? fair?
Why is min wage so controversial? Fairness? Efficiency?
Would you rather work at a lower wage or not work at all? How
does the graph and the min wage application show this scenario?
Why does min wage create and inefficient allocation of labour
resources?
82
questions
How does elasticity of demand affect tax incidence? Is elasticity
of supply and tax incidence any different?
Why is tax inefficient?
When would tax be efficient?
Alcohol, tobacco, and gasoline often have tax on them. Why ?
What are the principles of fairness applied to tax? Explain
What are the effects of subsidies and quotas?
Why are subsidies and quotas inefficient? Unfair?
Does voluntary production quota work?
83
questions
How does imposing a penalty on selling or buying influence
market for illegal drugs? Efficiencies? Qd? Qs?
Can you defend a case for legalizing drugs using economics?
What are the downsides to legalizing drugs? Economics? Other
concerns?
84
End of slides
85