Chapter 6: Government Policies That Alter the Private Market Outcome (Price Controls and Taxes)

Price Controls, Taxes, and Market Incidence – Study Notes

Price Controls: Overview

• Government policies that alter private market outcomes by constraining prices.

• Key types:

  • Price ceiling: legal maximum on the price at which a good can be sold.

  • Price floor: legal minimum on the price at which a good can be sold.

  • Examples: rent-control laws (price ceiling for housing), minimum wage laws (price floor for labor).

• Taxes: government can impose taxes (e.g., sales tax) to raise revenue; tax can be levied on buyers or sellers.

Price Ceilings

• A price ceiling above the equilibrium price is non-binding (no effect on market outcome).

• A price ceiling below the equilibrium price is binding and creates a shortage.

• Example 1: The Market for Apartments (equilibrium without price controls)

  • Equilibrium: $P^e = 800$, $Q^e = 300$ (Price $800, Quantity 300).

  • If price ceiling is set at $P_c = 1000$ (above equilibrium): non-binding; no change in outcome.

  • If price ceiling is set at $P_c = 500$ (below equilibrium): binding; creates a shortage.

  • With $P_c = 500$: quantity demanded exceeds quantity supplied; approximate values from transcript indicate demand around 400 and supply around 250, yielding a shortage of about 150 units (shortage ≈ 400 − 250).

• Shortages and rationing

  • Shortages force rationing mechanisms to allocate scarce goods among buyers.

  • Mechanisms:

  • First-come, first-served (long lines).

  • Discrimination by sellers’ biases.

  • Issues: allocations may be unfair or inefficient; goods may not go to those who value them most.

• Problems with price ceilings beyond shortages

  • Illegal markets: those who obtain the good may resell at higher prices.

  • Quality degradation: landlords may neglect maintenance under rent controls.

• Example 2: The Market for Unskilled Labor (equilibrium without price controls)

  • Equilibrium: $W^e = 6.00$, $Q^e = 500$ (Wage $6.00, 500 unskilled workers).

Price Floors (Minimum Wage)

• A price floor below the equilibrium price is non-binding (no effect).

• A price floor above the equilibrium price is binding and causes a surplus (unemployment).

• Example 1: The Market for Unskilled Labor

  • If the floor is set at $W_f = 5.00$ (below or at not binding relative to $6.00): non-binding; no effect.

  • If the floor is set above the equilibrium, e.g., at $W_f = 12.00$: binding; results in a surplus of labor (unemployment).

  • From transcript figures (illustrative): demand around 400, supply around 550; surplus ≈ 150 workers.

• Other problems with minimum wage

  • May encourage students to drop out of school (long-run cost).

  • Poorly targeted: fewer than a third of minimum-wage earners live in poverty; many are teenagers from middle-class families working part-time.

Active Learning: The Market for Hotel Rooms (Price Controls in Practice)

• Base scenario: market in equilibrium (no controls).

• A. $P_c = 90$ price ceiling (binding):

  • Equilibrium around $P^e <br>eq 90$; price falls to $P = 90<br>ight)$.

  • Demand: 120 rooms; Supply: 90 rooms; Shortage: $120 - 90 = 30$ rooms.

• B. $P_f = 90$ price floor (not binding):

  • Old equilibrium price is $P^e = 100$; price floor at 90 is non-binding.

  • Equilibrium remains at $P = 100$; Quantity = 100 rooms.

• C. $P_f = 120$ price floor (binding):

  • Price rises to $P = 120$; Demand: 60 rooms; Supply: 120 rooms; Surplus: $120 - 60 = 60$ rooms.

• Evaluating price controls

  • Markets are usually efficient at organizing economic activity, but most economists oppose price controls.

  • Prices balance supply and demand; price controls create shortages or surpluses.

Taxes: Raising Revenue and Their Incidence

• Taxes can raise revenue for roads, schools, national defense, etc.

• Tax incidence: how the burden of a tax is distributed between buyers and sellers; the legal assignment (who is taxed) does not always determine who bears the economic burden.

• Central idea: the effects on prices and quantities depend on elasticities; the tax wedge (difference between price paid by buyers and price received by sellers) equals the tax amount.

Example 3: The Market for Pizza (Tax on Buyers)

• Without tax (initial equilibrium):

  • Demand price willingness: $P^d = 10$; quantity: $Q = 500$.

• Tax on buyers of $T = 1.50$ per pizza:

  • Buyers’ price must adjust; to keep the same quantity, the price would need to fall by $T$ if demand were the only factor, leading to an observed shift in the demand curve by the tax amount.

  • New equilibrium: $Q = 450$; buyer price $P<em>B = 11.00$; seller price $P</em>S = 9.50$; tax collected = $T = 1.50$.

• Incidence of a buyer tax

  • Buyers pay $P_B = 11.00$ vs original $P = 10.00$ → buyers bear an additional $1.00$ of the tax burden.

  • Sellers receive $P_S = 9.50$ vs original $P = 10.00$ → sellers lose $0.50$ in receipt.

  • Total tax amount remains $1.50$, distributed as: buyers $1.00$, sellers $0.50$.

• A Tax on Sellers (equivalency)

  • Tax shifts the supply curve upward by the tax amount, causing the same changes in price and quantity as a buyer tax.

  • New equilibrium with a seller tax of $T = 1.50$: $Q = 450$; buyers pay $P<em>B = 11.00$; sellers receive $P</em>S = 9.50$; tax = $1.50$.

• The outcome is the same whether the tax is on buyers or sellers

  • The wedge between buyer price and seller price equals the tax: $P<em>B - P</em>S = T.</p></li><li><p>Despite who is legally taxed, the market outcome (prices paid and received, quantity, and tax incidence) is the same.</p></li></ul></li><li><p>Example: The market for hotel rooms (Active Learning 2)</p><ul><li><p>Suppose a tax on buyers of$30$per room is imposed.</p></li><li><p>New equilibrium:$Q = 80$; buyers pay$PB = 110$; sellers receive$PS = 80$; incidence: buyers pay$10$more, sellers lose$20$.</p></li><li><p>This illustrates how a tax can be allocated differently depending on elasticities, yet the total tax remains the same and the wedge persists.</p></li></ul></li></ul><h4 id="bc9670e0-46ad-4c41-bac0-3e68d59b2d58" data-toc-id="bc9670e0-46ad-4c41-bac0-3e68d59b2d58" collapsed="false" seolevelmigrated="true">Key Takeaways</h4><ul><li><p>Price ceilings below equilibrium create shortages and non-price rationing; may lead to illegal markets and reduced quality.</p></li><li><p>Price floors above equilibrium create surpluses (unemployment for labor markets).</p></li><li><p>Taxes create a wedge between what buyers pay and what sellers receive; the economic incidence depends on elasticities, not just on who is legally taxed;<br>the total tax burden is shared between buyers and sellers.</p></li><li><p>Policy implications: price controls are often ineffective at helping the intended beneficiaries and can have unintended adverse effects; alternative policies (rent subsidies, wage subsidies like the Earned Income Tax Credit) may better target those in need.</p></li></ul><p>$ ext{Equilibrium price without tax: } P = 10, ext{ Q = } 500.$<br>$ ext{Tax on buyers: } T = 1.50.$<br>$PB = 11.00, ext{ } PS = 9.50, ext{ } Q = 450.$<br>$PB - PS = T = 1.50.$<br>$ ext{Incidence (buyer: } 1.00 ext{, seller: } 0.50 ext{).}$$