Dr. Mohammed Alwosabi Econ140- ch.

Notes on Chapter 6
MARKETS IN ACTION

GOVERNMENT INTERVENTION
— In a free, unregulated market system, market forces establish equilibrium
prices and exchange quantities.
— While equilibrium conditions may be efficient, it may be true that not
everyone is satisfied. Sometimes the market equilibrium outcome is
perceived by certain groups or individuals to be unfair or unjust, which
may lead to government intervention.
— Government can intervene in such markets in any number of ways,
including the banning of the production and consumption of certain goods
and services entirely, regulating industries such as banking that it deems
too sensitive to be left alone, and imposing price control.
— We focus on two methods of government intervention: price ceilings and
price floors.

P S
PRICE CEILING
Max black market price
— Price ceiling is the maximum price
which can be legally charged. It is illegal
P*
to charge a price higher than the price
Illegal
ceiling. Pc

— Rent ceiling is a good example of price shortage

Legal
D
ceiling
Q
— The effect of price ceiling (Pc) depends Qc Q* Qd

on whether it is imposed at a level that is above or below the equilibrium

price (P*)
— If Pc > P*, it has no effect because Pc cannot control the market forces
from reaching the equilibrium

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Dr. Mohammed Alwosabi Econ140- ch.6

— For a price ceiling to be effective, the price must be below market

equilibrium price (P*)
— If Pc < P* it has effect on market forces. Market forces cannot reach
equilibrium ⇒ Qd > Qs ⇒ shortage
— Shortage leads to
(1) Increasing Search Activity:
o The time spent looking for someone to do business with. When
price ceiling results in shortage, search activity increases Ö
opportunity cost increases.
o Opportunity cost of a good = its price + the value of the time and
other resource spent to find the good
o Rent ceiling control the rent but not the opportunity cost which
might be higher than the rent
(2) Creation of Black Market:
o Black market refers to the illegal transactions. In this case, the price
exceeds the legally imposed price ceiling.
o With apartment price ceilings (rent ceiling), underground markets often
appear in which landlords and tenants agree to the "official" contract rate
but tenants agree to make additional side-payments.
o In addition, if landlords cannot set prices, they begin to adjust the quality
of their apartments, letting them fall into disrepair. Some tenants end up
living in unkempt conditions and are afraid to report the landlord because
they may find themselves homeless if the landlord quits renting the
apartment.
— Are these price ceilings justified? It depends. Equity is a subjective
concept.
— Price ceilings help some groups and hurt others. For example, rent ceiling
helps tenants who pay below-market rents but hurt landlords and other
prospective tenants who are shut out of the market due to the shortage.

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Dr. Mohammed Alwosabi Econ140- ch.6

PRICE FLOOR
— Price floor is the minimum price which can be legally charged. It is
illegal to charge a price lower than the price P S

floor Surplus
(unemployment)
— If Pf < P* it has no effect on market forces Pf

because Pf cannot control the market forces Legal area

P*
Illegal area
from reaching the equilibrium
— For a price floor to be effective, the price
D
must be above market equilibrium price (P*)
— If Pf > P*, it is effective on market forces. Q
Qd Q* Qf
Market cannot reach equilibrium ⇒ Qs > Qd
⇒ surplus.
— To maintain the price floor, government should buy the surplus amount
from the market
— Common examples of price floors are found in labor market and in
agricultural markets.
— When a price floor is applied to labor market it is called a minimum wage.
— The purpose of minimum wage laws is to raise the wages of the low-
skilled workers
— In labor market, an effective minimum wage (a minimum wage above the
labor market equilibrium wage) results in a surplus of low-skilled workers
(the quantity of labor supplied would be greater than the quantity of labor
demanded). This kind of surplus is called unemployment.
— The existence of unemployment results in:
(1) wasted labor resources
(2) inefficient amount of job search
— A tradeoff occurs between equity and efficiency with price floor.
— Some groups benefit while others lose. In the case of the minimum wage,
those who are able to find the higher paying jobs benefit. Employers who

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Dr. Mohammed Alwosabi Econ140- ch.6

must pay higher wages lose along with those in the labor force who cannot
find jobs because wages are too high.
— Agricultural price floors benefit farmers at the expense of consumers.
— Nevertheless, society has thus far deemed the benefits received from the
price floors to be worth the costs.

ELASTICITY AND TAXATION

— Taxation is used to illustrate the usefulness of elasticity in analyzing and
understanding economic issues.
— The main question to be addressed in this application is the understanding
of who pays for taxes on goods and services imposed by the government –
consumers or firms? When asked, most people (consumers) commonly
respond with the belief that they do, that firms simply pass taxes on to
them. But is this really the case or not?
— Tax incidence is the division of the tax burden between the buyers and
the sellers.
— Taxes are divided into a direct tax such as income tax or indirect tax
such as sales tax.
— In this application we will focus only on how sales tax is divided between
consumers and sellers
— A sales tax is a tax on consumption. It is normally a certain percentage
that is added onto the price of a good or service that is purchased and is
collected by the sellers.
— Sales tax is imposed on sellers. However, sellers may divert some or all of
the tax to buyers.
— Imposing a sales tax on a good or service decreases the supply. The tax
shifts the supply curve leftward by the amount of the tax. The vertical
distance between the supply curve with the tax and the supply curve

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Dr. Mohammed Alwosabi Econ140- ch.6

without the tax equals the amount of the tax. Generally, the quantity
decreases and the price rises but by less than the amount of the tax.
— To understand this concept let us start with the following example

— Example: P
S + tax
o This example is based on the demand and 110 S
supply presented in the graph below, $10 tax
105
o Initially, without tax, the market is in 5
100
equilibrium at P* = 100 and Q* = 5000 5

units of good X. Consumers pay $100 and 95

D
sellers receive $100 per unit.
o Suppose government imposed a $10 sales
0
4 5 Q
tax
o Supply decreases and supply curve shifts leftward by the amount of tax.
o The amount of tax is measured by the vertical distance between the
original supply curve (before tax) and the supply curve after the tax
(which is $10 at every quantity)
o If consumers pay the whole tax they will pay now $110 for the good
and sellers will receive $100 ($110 - $10). This price is expensive to
many consumers but it is a good price to many producers because they
will get the same old price. Ö Qs > Qd Ö surplus Ö pressure on price
to go down until it reaches the equilibrium price at P* = 105
o If sellers pay the whole tax, buyers will pay P = 100 as before but
sellers will receive only $90 ($100 - $10). This price is too low to
many producers but it is good price to many consumers Ö Qd > Qs Ö
shortage Ö pressure on price to go up until it reaches the equilibrium
price at P* = 105
o Therefore, the market equilibrium price with tax is P* = 105 and
equilibrium quantity decreases to Q* = 4000

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Dr. Mohammed Alwosabi Econ140- ch.6

o At the equilibrium price of P* = 105, buyer’s share of the $10 tax is

the difference between the new P* with tax and the old P* without tax
(105 – 100 = $5);
o The sellers pay the difference between the tax amount and what buyers
pay.($10 - $5 = $5)
o In this example, buyers and sellers pay the $10 tax equally
• Government tax revenue = (the tax amount) (the equilibrium
quantity after the tax)
= 10 * 4000 = 40,000
• Buyers pay (105 - 100) * 4000 = 20,000
• Sellers pay (100 - 95) * 4000 = 20,000
— Imposing a sales tax on the good is usually paid by both buyers and sellers.
The division of tax between buyers and sellers depends on the elasticities
of demand and supply.

Tax Division and the Elasticity of Demand:

— The division of the tax between the buyers and the sellers depends, in part,
on the elasticity of demand.
— To understand this concept we show the two extreme cases of the
elasticity of demand and from them we draw our conclusion
P
D
Perfectly Inelastic Demand S + tax
S
— For a good, the equilibrium with no tax:
P* = $5, Q* = 100 units
6
— Government imposed a $1 sales tax on
this good ⇒ SC shifts to S + tax
— Since demand is perfectly inelastic, 5 Q
0 100
a rise in the price to consumers does
not result in a reduction in Qd. With the increase in P from 5 to 6, buyers
continue to consume 100 units.

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Dr. Mohammed Alwosabi Econ140- ch.6

— Likewise, firms continue to produce 100 units because their price remains
at $5 (PC – tax).
— With tax, P* = 6 and Q* = 100
o Government collects $1 *100 = $100
o Consumers pay ($6-$5) *100 = $100
o Producers pay ($5-$5) * 100 = 0
o Thus, in this example, when demand is perfectly inelastic, buyers
pay the entire tax and sellers pay nothing,

P
Perfectly Elastic Demand S + tax

— Initially, equilibrium with no tax S

P* = 2, Q* = 10,000
2 D
— Government imposed a $0.50 sales tax
⇒ SC shifts to S + tax
— Price paid by buyers is unchanged but 1.5

tax lowered the amount received by

0 Q
sellers by the entire tax and quantity 4 10

sold decreases from 10,000 to 4000

— With tax, P* = 2 and Q* = 4,000
o Government collects $0.5 *4000 = $2000
o buyers pay ($2-$2) *4000 = $0
o sellers pay ($2-$1.5) * 4000 = 2000
Thus, buyers pay nothing and sellers pay the entire tax
— When demand is perfectly inelastic the buyers pay the entire tax
— When demand is perfectly elastic the sellers pay the entire tax
— Usually demand is neither perfectly inelastic nor perfectly elastic and the
tax amount splits between buyers and sellers. But the division depends on
the elasticity of demand
o The more inelastic the demand is, the larger is the increase in P*
and the larger the amount of tax paid by the buyers

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Dr. Mohammed Alwosabi Econ140- ch.6

o The more elastic is the demand, the smaller is the increase in P*

and the larger the amount of the tax paid by the sellers
o The larger is the change in equilibrium price, the more the buyers
pay and the less the sellers pay.
— It is unusual to tax an item heavily if its demand is elastic. Such an item
has closed substitutes. If a tax is levied on such an item the demand for the
taxed item will decrease and the demand for the untaxed substitute will
increase. Therefore, government will not collect much tax revenue ⇒
items taxed are those that have inelastic demand and buyers pay most of
the tax

Tax Division and the Elasticity of Supply:

— The division of the tax between the buyers and the sellers also depends, in
part, on the elasticity of supply.
— To understand this concept we show the two extreme cases of the
elasticity of supply and from them we will P
S
reach our conclusion

Perfectly Inelastic Supply 50

— Initially, equilibrium with no tax

45
P* = 50, Q* = 100,000
— With $5 tax per unit, SC does not change D
0
and buyers are willing to buy the entire 100 Q

quantity only if P = $50⇒ sales tax reduces the prices received by sellers
to $45 per unit
o Government collects $5 *100,000 = $500,000
o Buyers pay ($50-$50) *100,000 = $0
o Sellers pay ($50-$45) * 100,000 = $500,000
Thus, sellers pay the entire tax and buyers pay nothing

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Dr. Mohammed Alwosabi Econ140- ch.6

Perfectly Elastic Supply

— With no tax, P* = 10, Q* = 5000
— With $1 tax, sellers are willing to
offer any quantity at P* = 11 per unit
P
along S + tax curve.
— The sales tax increases the price
paid by the buyers by the full amount 11 S + tax
of the tax and decreased the quantity
10 S
sold to Q* = 3000
o Government collects $1 *3000 = $3000 D

o buyers pay ($11-$10) *3000 = $3000 Q

0 3 5
o sellers pay ($10-$10) * 3000 = $0
Thus, buyers pay the entire tax and sellers pay nothing
— When supply is perfectly inelastic the sellers pay the entire tax
— When supply is perfectly elastic the buyers pay the entire tax
— Usually supply is neither perfectly inelastic nor perfectly elastic and the
tax amount splits between buyers and sellers. But the division depends on
the elasticity of supply
o The more inelastic is the supply, the larger the amount of tax paid
by the sellers
o The more elastic is the supply, the larger the amount of the tax paid
by the buyers
— The more inelastic is the supply, the more tax government will collect
because price will increase by the tax amount but quantity will not
decrease as much.
— Tax policy is more effective when tax is levied on goods with high
inelastic demand and goods with high inelastic supply

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Dr. Mohammed Alwosabi Econ140- ch.6

SALES TAX
DEMAND SUPPLY
Sellers
Elasticity Buyers Pay Buyers Pay Sellers Pay
Pay
Perfectly The entire The entire
Nothing Nothing
Inelastic tax tax
The entire The entire
Perfectly Elastic Nothing Nothing
tax tax
Neither Paid by both buyers and Paid by both buyers and
Perfectly sellers depending on the sellers depending on the
Inelastic Nor elasticities of demand and elasticities of demand and
Perfectly Elastic supply supply

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