0. Application: The Costs of Taxation and Price Regulations8
Application: The Costs of Taxation and Price Regulations
Economics
P R I N C I P L E S O F
N. Gregory Mankiw
This chapter builds very closely on material from the previous three chapters: it uses the tools of welfare economics (from Chapter 7) to analyze the effects of a tax (introduced in Chapter 6). It explores the relationship between the price elasticities of demand and supply (Chapter 5) with the deadweight loss of the tax. Covering this chapter immediately after the previous three will reinforce the concepts students learned in those chapters.
The material in chapter 8 is important. The government must raise revenue to pay for the police, the court system, interstate highways, national defense, public education, and so forth. The government must choose which goods to tax and how much to tax each one. Effective tax policy generates the needed revenue while striving for (the sometimes conflicting goals of) efficiency and equity.
This is not one of the longer chapters; most instructors cover it in 1.5 or 2 hours of class time. But if you’re pressed for time and looking for things to cut, you might consider cutting some of these (my personal suggestions, not the official recommendations of Greg Mankiw or South-Western/Cengage):
Revenue and the size of the tax, the Laffer Curve
DWL and the size of the tax
Active Learning 3, the slide with the discussion question on whether to tax groceries or meals at fancy restaurants
Active Learning 2
Premium PowerPoint Slides by Ron Cronovich

1. In this chapter, look for the answers to these questions:
How does a tax affect consumer surplus, producer surplus, and total surplus?
What is the deadweight loss of a tax?
What factors determine the size of this deadweight loss?
How does tax revenue depend on the size of the tax?
What are price ceilings and price floors? What are some examples of each?
How do price ceilings and price floors affect market outcomes? 1

2. Review from Chapter 6 A tax
drives a wedge between the price buyers pay and the price sellers receive.
raises the price buyers pay and lowers the price sellers receive.
reduces the quantity bought & sold.
These effects are the same whether the tax is imposed on buyers or sellers, so we do not make this distinction in this chapter.
If you wish, you may delete this slide and give the information verbally as you cover the following slide.
APPLICATION: THE COSTS OF TAXATION 2

3. The Effects of a Tax Eq’m with no tax: Price = PE Quantity = QED S
Eq’m with no tax: Price = PE Quantity = QE
Size of tax = $T PB
Eq’m with tax = $T per unit: QT PE QE
Buyers pay PB PS
Sellers receive PS
Quantity = QT
APPLICATION: THE COSTS OF TAXATION 3

4. Revenue from tax: $T x QT
The Effects of a Tax P Q
Revenue from tax: $T x QT
Size of tax = $T S PB PE PS D QT QE
APPLICATION: THE COSTS OF TAXATION 4

5. The Effects of a Tax
Next, we apply welfare economics to measure the gains and losses from a tax.
We determine consumer surplus (CS), producer surplus (PS), tax revenue, and total surplus with and without the tax.
Tax revenue can fund beneficial services (e.g., education, roads, police) so we include it in total surplus.
If you wish, you may delete this slide and give the information verbally at the beginning of the next slide.
APPLICATION: THE COSTS OF TAXATION 5

6. The Effects of a Tax Without a tax, CS = A + B + C PS = D + E + FQ D S
Without a tax,
CS = A + B + C
PS = D + E + F A
Tax revenue = 0 B C
Total surplus = CS + PS
= A + B + C D + E + F PE QE E D F QT
APPLICATION: THE COSTS OF TAXATION 6

7. The Effects of a Tax With the tax, CS = A PS = F Tax revenue = B + DQ
With the tax,
CS = A
PS = F A
Tax revenue = B + D S PB B C
Total surplus = A + B + D + F E D PS D F
The tax reduces total surplus by C + E QT QE
APPLICATION: THE COSTS OF TAXATION 7

8. The Effects of a Tax P Q
C + E is called the deadweight loss (DWL) of the tax, the fall in total surplus that results from a market distortion, such as a tax. A S PB B C E D PS D F QT QE
APPLICATION: THE COSTS OF TAXATION 8

9. About the Deadweight LossP Q
Because of the tax, the units between QT and QE are not sold.
The value of these units to buyers is greater than the cost of producing them,
so the tax prevents some mutually beneficial trades. S PB PS D QT QE
APPLICATION: THE COSTS OF TAXATION 9

10. A C T I V E L E A R N I N G 1 Analysis of tax
The market for airplane tickets P Q $
A. Compute CS, PS, and total surplus without a tax.
B. If $100 tax per ticket, compute CS, PS, tax revenue, total surplus, and DWL. D S
In chapter 7, students learned how to compute the area of triangles representing CS, PS, and total surplus. This skill is required to do this exercise.
Most students will need a calculator to do part B.
Your students need not draw the graph in order to do these calculations. However, if your students are using the gutted student handouts we provide to accompany the Premium PowerPoint presentations, they will have parts of the graph on their handouts. Ask your students to shade the areas corresponding to CS, PS, tax revenue and DWL directly on the printed graphs. 10

11. A C T I V E L E A R N I N G 1 Answers to A
The market for airplane tickets P Q $ CS
= ½ x $200 x 100
= $10,000 D S PS
= ½ x $200 x 100
= $10,000
P =
Total surplus
= $10,000 + $10,000
= $20,000 11

12. A C T I V E L E A R N I N G 1 Answers to B
A $100 tax on airplane tickets P Q $ CS
= ½ x $150 x 75
= $5,625 D S
PS = $5,625
PB =
Tax revenue
= $100 x 75
= $7,500
PS =
To compute DWL, simply subtract total surplus with the tax ($18750) from total surplus without the tax ($20,000, which was computed on the preceding slide).
Equivalently, compute the area of the blue shaded triangle:
½ x (100-75) x ($250 – $150) = $1250.
Total surplus = $18,750
DWL = $1,250 12

13. What Determines the Size of the DWL?
Which goods or services should govt tax to raise the revenue it needs?
One answer: those with the smallest DWL.
When is the DWL small vs. large? Turns out it depends on the price elasticities of supply and demand.
Recall: The price elasticity of demand (or supply) measures how much QD (or QS) changes when P changes.
APPLICATION: THE COSTS OF TAXATION 13

14. DWL and the Elasticity of Supply
When supply is inelastic,
it’s harder for firms to leave the market when the tax reduces PS.
So, the tax only reduces Q a little,
and DWL is small. P Q S D
Size of tax
When there’s no tax, the market equilibrium quantity maximizes total surplus.
The tax causes the price sellers receive to fall, so sellers will supply a smaller quantity, and the new equilibrium quantity falls below the one that maximizes total surplus – hence the DWL.
When supply is inelastic, sellers do not reduce Q much below the surplus-maximizing quantity, so DWL is small.
APPLICATION: THE COSTS OF TAXATION 14

15. DWL and the Elasticity of Supply
The more elastic is supply,
the easier for firms to leave the market when the tax reduces PS,
the greater Q falls below the surplus-maximizing quantity,
the greater the DWL. P Q D S
Size of tax
In this graph, the demand curve, equilibrium price, and size of the tax are identical to those in the graph on the preceding slide. The only thing that’s different is the supply curve here is flatter; as a result, the same size tax as before causes a larger DWL.
APPLICATION: THE COSTS OF TAXATION 15

16. DWL and the Elasticity of Demand
When demand is inelastic,
it’s harder for consumers to leave the market when the tax raises PB.
So, the tax only reduces Q a little,
and DWL is small. P Q D S
Size of tax
The tax raises the price buyers pay and therefore reduces the quantity demanded. The equilibrium quantity falls below the surplus-maximizing quantity, but not by much when demand is price-inelastic.
APPLICATION: THE COSTS OF TAXATION 16

17. DWL and the Elasticity of Demand
The more elastic is demand,
the easier for buyers to leave the market when the tax increases PB,
the more Q falls below the surplus-maximizing quantity,
and the greater the DWL. P Q S D
Size of tax
In this graph, the supply curve, equilibrium price, and size of the tax are identical to those in the graph on the preceding slide. The only thing that’s different is the demand curve here is flatter; as a result, the same size tax as before causes a larger DWL.
APPLICATION: THE COSTS OF TAXATION 17

18. A C T I V E L E A R N I N G 2 Elasticity and the DWL of a tax
Would the DWL of a tax be larger if the tax were on:
A. Breakfast cereal or sunscreen?
B. Hotel rooms in the short run or hotel rooms in the long run?
C. Groceries or meals at fancy restaurants?
These examples (breakfast cereal vs. sunscreen) were chosen not because they are exciting real-world policy debates, but because they link back to the examples used in Chapter 5 to help students deduce the factors that determine elasticity.
Suggestion: Display all three questions and give students a few moments to think about it. Then, proceed to the following slides…
It might be worth mentioning the following to students:
For each pair of goods, we are considering taxes of similar relative magnitude. E.g., it wouldn’t be fair to ask whether a $10 per bottle tax on sunscreen has a bigger DWL than a $0.01 tax on boxes of breakfast cereal. 18

19. A C T I V E L E A R N I N G 2 Answers
A. Breakfast cereal or sunscreen
From Chapter 5: Breakfast cereal has more close substitutes than sunscreen, so demand for breakfast cereal is more price-elastic than demand for sunscreen.
So, a tax on breakfast cereal would cause a larger DWL than a tax on sunscreen.
Suggestion: Display the first line, then invite students to volunteer their answers before displaying the explanation. 19

20. A C T I V E L E A R N I N G 2 Answers
B. Hotel rooms in the short run or long run
From Chapter 5: The price elasticities of demand and supply for hotel rooms are larger in the long run than in the short run.
So, a tax on hotel rooms would cause a larger DWL in the long run than in the short run. 20

21. A C T I V E L E A R N I N G 2 Answers
C. Groceries or meals at fancy restaurants
From Chapter 5: Groceries are more of a necessity and therefore less price-elastic than meals at fancy restaurants.
So, a tax on restaurant meals would cause a larger DWL than a tax on groceries. 21

22. A C T I V E L E A R N I N G 3 Discussion question
The government must raise tax revenue to pay for schools, police, etc. To do this, it can either tax groceries or meals at fancy restaurants.
Which should it tax?
Engage your students and give them a brief break from lecture. Show this slide and ask for students to volunteer their thoughts. The question on this slide will almost certainly elicit a few different opinions.
Of course, there is no single “correct” answer – one choice is not unambiguously better than the other. A tax on groceries would be more efficient (smaller DWL) than a tax on restaurant meals. However, a tax on groceries would hurt people with low incomes proportionately more than people with higher incomes, as the former spend a larger percentage of their income on groceries. Hence, such a tax would be regressive.
Once again, we see the tradeoff between efficiency and equity/equality. 22

23. How Big Should the Government Be?
A bigger government provides more services, but requires higher taxes, which cause DWLs.
The larger the DWL from taxation, the greater the argument for smaller government.
The tax on labor income is especially important; it’s the biggest source of govt revenue.
For the typical worker, the marginal tax rate (the tax on the last dollar of earnings) is about 40%.
How big is the DWL from this tax? It depends on elasticity….
The next few slides are adapted from the section “Case Study: The Deadweight Loss Debate” in this chapter of the textbook. The title of this slide is actually a direct quote from this section. I think it makes a catchier title for these slides than “the deadweight loss debate.”
Why the marginal tax rate is relevant: One of the 10 Principles from Chapter 1 is “rational people think at the margin.” This applies to workers, as well. When Susan considers increasing her hours, she takes into account the extra income she’d earn from working a few more hours a week. The extra income on each additional hour equals the hourly wage minus the marginal tax rate.
APPLICATION: THE COSTS OF TAXATION 23

24. How Big Should the Government Be?
If labor supply is inelastic, then this DWL is small.
Some economists believe labor supply is inelastic, arguing that most workers work full-time regardless of the wage.
According to this view, the DWL from labor taxes is small. This is relevant to the question “how big should the government be?”, because a high DWL would argue for restraining the size of government.
APPLICATION: THE COSTS OF TAXATION 24

25. How Big Should the Government Be?
Other economists believe labor taxes are highly distorting because some groups of workers have elastic supply and can respond to incentives:
Many workers can adjust their hours, e.g., by working overtime.
Many families have a 2nd earner with discretion over whether and how much to work.
Many elderly choose when to retire based on the wage they earn.
Some people work in the “underground economy” to evade high taxes.
The textbook has an “In The News” box containing an excellent WSJ article on the effect of tax rates on work effort.
APPLICATION: THE COSTS OF TAXATION 25

26. The Effects of Changing the Size of the Tax
Policymakers often change taxes, raising some and lowering others.
What happens to DWL and tax revenue when taxes change? We explore this next….
APPLICATION: THE COSTS OF TAXATION 26

27. DWL and the Size of the TaxP Q D S
Initially, the tax is T per unit.
new DWL
Doubling the tax 2T Q2
causes the DWL to more than double. T Q1
initial DWL
The new DWL is four times the initial DWL, even though the tax is just twice as large.
APPLICATION: THE COSTS OF TAXATION 27

28. DWL and the Size of the TaxP Q D S
new DWL
Initially, the tax is T per unit. 3T Q3
Tripling the tax
causes the DWL to more than triple. Q1 T
initial DWL
The new DWL is nine times the initial DWL, even though the tax is only three times as large.
APPLICATION: THE COSTS OF TAXATION 28

29. DWL and the Size of the Tax
Implication
When tax rates are low, raising them doesn’t cause much harm, and lowering them doesn’t bring much benefit.
When tax rates are high, raising them is very harmful, and cutting them is very beneficial.
Summary
When a tax increases, DWL rises even more.
DWL
Tax size
The “implication” in the green box is not in the textbook, so it is not supported in the study guide or test bank. You may wish to delete it from this slide.
If you keep it, note that the “harm” of raising taxes and the “benefit” of lowering them refer to the impact on total surplus.
APPLICATION: THE COSTS OF TAXATION 29

30. Revenue and the Size of the Tax
When the tax is small, increasing it causes tax revenue to rise. P Q D S PB Q2 2T PB Q1 T PS PS
When the tax is small (namely, equal to T), the shaded yellow rectangle represents tax revenue.
When the tax equals 2T, the pink shaded box represents revenue.
The pink shaded box is larger than the yellow box.
APPLICATION: THE COSTS OF TAXATION 30

31. Revenue and the Size of the TaxP Q D S PB Q3 3T PB Q2
When the tax is larger, increasing it causes tax revenue to fall. 2T PS
Raising the tax further – to 3T – causes revenue to fall. Revenue is now represented by the bluish-purple shaded box, which is smaller than the pink box. PS
APPLICATION: THE COSTS OF TAXATION 31

32. Revenue and the Size of the Tax
The Laffer curve shows the relationship between the size of the tax and tax revenue.
The Laffer curve
Tax size
Tax revenue
The Laffer curves shown here and in the book are symmetric, and their peak occurs in the middle. You might mention to students that this need not and probably is not the case. However, we just don’t know where the peak is – it could be at a tax rate of 20% or a tax rate of 200% - and it surely varies across goods.
The textbook has some excellent discussion of the Laffer curve, President Reagan, and supply-side economics. Encourage your students to check it out.
APPLICATION: THE COSTS OF TAXATION 32

33. Government Policies That Alter the Private Market Outcome
Price controls
Price ceiling: a legal maximum on the price of a good or service Example: rent control
Price floor: a legal minimum on the price of a good or service Example: minimum wage
Taxes
The govt can make buyers or sellers pay a specific amount on each unit bought/sold.
This slide outlines the chapter.
SUPPLY, DEMAND, AND GOVERNMENT POLICIES 33

34. Example 1: Price Ceilings
The Economic Effect of a Rent Ceiling
Without rent control, the equilibrium rent is $1,500 per month.
At that price, 2,000,000 apartments would be rented.
If the government imposes a rent ceiling of $1,000, the quantity of apartments supplied falls to 1,900,000,
and the quantity of apartments demanded increases to 2,100,000,
resulting in a shortage of 200,000 apartments.
Don’t Let This Happen to You
Don’t Confuse “Scarcity” with “Shortage”
There is no shortage of most scarce goods.
Your Turn: Test your understanding by doing related problem 3.15 at the end of this chapter.
MyEconLab

35. Example 1: PRICE CEILINGS
A price ceiling above the eq’m price is not binding – has no effect on the market outcome. P Q S
Price ceiling
$2000 D
$1500 20
When some students see this for the first time, they wonder why the price ceiling does not result in a surplus.
When the price ceiling is above the equilibrium price, the equilibrium price is still perfectly legal. Just because landlords are allowed to charge $1000 rent doesn’t mean they will – if they do, they won’t be able to rent all of their apartments – a surplus will result, causing downward pressure on the price (rent). There’s no law that prevents the price (rent) from falling, so it does fall until the surplus is gone and equilibrium is reached (at P = $800 and Q = 300).
SUPPLY, DEMAND, AND GOVERNMENT POLICIES 35

36. How Price Ceilings Affect Market Outcomes
The eq’m price ($800) is above the ceiling and therefore illegal.
The ceiling is a binding constraint on the price, causes a shortage. P Q S D
$1500
Price ceiling
$1000 19 21
shortage
In this case, the price ceiling is binding.
In the new equilibrium with the price ceiling, the actual price (rent) of an apartment will be $500. It won’t be more than that, because any higher price is illegal. It won’t be less than $500, because the shortage would be even larger if the price were lower.
The actual quantity of apartments rented equals 250, and there is a shortage equal to 150 (the difference between the quantity demanded, 400, and the quantity supplied, 250).
SUPPLY, DEMAND, AND GOVERNMENT POLICIES 36

37. Shortages and Rationing
With a shortage, sellers must ration the goods among buyers.
Some rationing mechanisms: (1) Long lines (2) Discrimination according to sellers’ biases
These mechanisms are often unfair, and inefficient: the goods do not necessarily go to the buyers who value them most highly.
In contrast, when prices are not controlled, the rationing mechanism is efficient (the goods go to the buyers that value them most highly) and impersonal (and thus fair).
The last two bullets discuss “efficiency” in the context of rationing goods to those buyers who value them most highly. This concept will be explored further in the following chapter.
SUPPLY, DEMAND, AND GOVERNMENT POLICIES 37

38. 類似的例子: 路邊停車收費 Price (per hour) S D E $30 Price ceiling A B Quantity
Figure Caption:
Figure 5-2: The Effects of a Price Ceiling
The black horizontal line represents the government-imposed price ceiling on rents of $800 per month. This price ceiling reduces the quantity of apartments supplied to 1.8 million, point A, and increases the quantity demanded to 2.2 million, point B. This creates a persistent shortage of 400,000 units: 400,000 people who want apartments at the legal rent of $800 but cannot get them
Price ceiling A B
Quantity
Shortage 38

39. 停車位有市場價值，不收費的路邊停車位形成短缺。
不收費時， 永遠無空車位。
不收費的缺點:
Inefficient Allocation: 急需要車位的停不到
Wasted Resources: 找車位的時間浪費

40. How Price Ceilings Cause Inefficiency
Inefficiently Low Quantity
the quantity transacted is below the efficient market equilibrium quantity
Inefficient Allocation to Customers
Wasted Resources
Inefficiently Low Quality
Black Markets 40

41. More Problems Caused by Price Ceilings
Inefficient Allocation to consumers: people who want the good badly and are willing to pay a high price don’t get it, and those who care relatively little about the good and are only willing to pay a low price do get it.
Wasted Resources: people expend money, effort and time to cope with the shortages caused by the price ceiling. 41

42. More Problems Caused by Price Ceilings
Inefficiently Low Quality: sellers offer low-quality goods at a low price even though buyers would prefer a higher quality at a higher price.
A black market is a market in which goods or services are bought and sold illegally—either because it is illegal to sell them at all or because the prices charged are legally prohibited by a price ceiling. However, a black market may improve efficiency. 42

43. Price Ceilings: Government Rent Control Policy in Housing Markets
The Economic Effect of a Rent Ceiling
Without rent control, the equilibrium rent is $1,500 per month.
At that price, 2,000,000 apartments would be rented.
If the government imposes a rent ceiling of $1,000, the quantity of apartments supplied falls to 1,900,000,
and the quantity of apartments demanded increases to 2,100,000,
resulting in a shortage of 200,000 apartments.
Producer surplus equal to the area of the blue rectangle A is transferred from landlords to renters,
and there is a deadweight loss equal to the areas of yellow triangles B and C.
Black market A market in which buying and selling take place at prices that violate government price regulations.

44. What’s the Economic Effect of a Black Market for Apartments?
Suppose that competition among tenants results in the black market rent rising to $2,000 per month. Use a graph showing the market for apartments, noting any differences in consumer surplus, producer surplus, and deadweight loss.
Solving the Problem
Step 1: Review the chapter material.
Step 2: Draw a graph similar to Figure 4.9, with the addition of the black market price.
Step 3: Analyze the changes from Figure 4.9.
Producer surplus has increased by an amount equal to rectangles A and E, and consumer surplus has declined by the same amount.
Deadweight loss is equal to triangles B and C, the same as in Figure 4.9.
The remaining consumer surplus is the blue triangle D.
Eventually, the market could even end up at the competitive equilibrium.
Your Turn: For more practice, do related problem 3.14 at the end of this chapter.
MyEconLab

45. EXAMPLE 2: The Market for Unskilled LaborW L
Wage paid to unskilled workers S D $4
500
Eq’m w/o price controls
Now we switch gears and look at the effects of a price floor. We illustrate this concept using the common textbook example – the minimum wage.
This may be the first time students have seen a supply-demand diagram of the labor market. It might be useful to note that the “price” of labor is simply the wage, which we measure on the vertical axis of our supply-demand diagram. Along the horizontal axis, we measure the quantity of labor (number of workers). The demand for unskilled labor comes from firms. The supply comes from workers.
We focus on unskilled labor because the minimum wage is not relevant for higher skilled, higher wage workers.
Quantity of unskilled workers
SUPPLY, DEMAND, AND GOVERNMENT POLICIES 45

46. How Price Floors Affect Market Outcomes
A price floor below the eq’m price is not binding – has no effect on the market outcome. W L S D $4
500
Price floor $3
Some students may wonder why the $3 price floor does not cause a shortage. After all, at a wage of $3, the quantity of unskilled workers that firms wish to hire exceeds the quantity of unskilled workers that are looking for jobs.
But the minimum wage law does not stop the wage from rising above $3. So, in response to this shortage, the wage will rise until the shortage disappears – which occurs at the equilibrium wage of $4. The equilibrium wage is perfectly legal when the price floor (i.e. minimum wage) is below it.
SUPPLY, DEMAND, AND GOVERNMENT POLICIES 46

47. How Price Floors Affect Market Outcomes
labor surplus
The eq’m wage ($4) is below the floor and therefore illegal.
The floor is a binding constraint on the wage, causes a surplus (i.e., unemployment). W L S
Price floor $5 D
400
550 $4
Now, the minimum wage exceeds the equilibrium wage. The equilibrium wage (or any wage below $5) is illegal.
In this case, the actual wage will be $5. It will not be lower, because any lower wage is illegal. It will not be higher, because at any higher wage, the surplus would be even greater. The actual number of unskilled workers with jobs equals want jobs, but firms are only willing to hire 400, leaving a surplus (i.e. unemployment) of 150 workers.
A surplus of anything – especially labor – represents wasted resources.
SUPPLY, DEMAND, AND GOVERNMENT POLICIES 47

48. Price Floors: Government Policy in Agricultural Markets
The Economic Effect of a Price Floor in the Wheat Market
If wheat farmers convince the government to impose a price floor of $3.50 per bushel, the amount of wheat sold will fall from 2.0 billion bushels per year to 1.8 billion.
If we assume that farmers produce 1.8 billion bushels, producer surplus then increases by the red rectangle A—which is transferred from consumer surplus—and falls by the yellow triangle C.
Consumer surplus declines by the red rectangle A plus the yellow triangle B.
There is a deadweight loss equal to the yellow triangles B and C, representing the decline in economic efficiency due to the price floor.
In reality, a price floor of $3.50 per bushel will cause farmers to expand their production from 2.0 billion to 2.2 billion bushels, resulting in a surplus of wheat.

49. The Minimum Wage Min wage laws do not affect highly skilled workers.
They do affect teen workers.
Studies: A 10% increase in the min wage raises teen unemployment by 1-3%.
unemp-loyment W L S
Min. wage $5 D
400
550 $4
SUPPLY, DEMAND, AND GOVERNMENT POLICIES 49

50. A C T I V E L E A R N I N G 1 Price controlsQ P S
The market for hotel rooms D
Determine effects of:
A. $90 price ceiling
B. $90 price floor
C. $120 price floor
A good exercise to break up the lecture, engage students, and assess their learning so far. 50

51. A C T I V E L E A R N I N G 1 A. $90 price ceilingQ P S
The market for hotel rooms D
The price falls to $90.
Buyers demand 120 rooms, sellers supply 90, leaving a shortage.
Price ceiling
shortage = 30 51

52. A C T I V E L E A R N I N G 1 B. $90 price floorQ P S
The market for hotel rooms D
Eq’m price is above the floor, so floor is not binding.
P = $100, Q = 100 rooms.
Price floor 52

53. A C T I V E L E A R N I N G 1 C. $120 price floorQ P S
The market for hotel rooms D
The price rises to $120.
Buyers demand 60 rooms, sellers supply 120, causing a surplus.
surplus = 60
Price floor 53

54. How a Price Floor Causes Inefficiency
Inefficiently low quantity
Inefficient allocation of sales among sellers
Wasted resources
Inefficiently high quality
Temptation to break the law by selling below the legal price 54

55. More problems caused by a price floor
Price floors lead to inefficient allocation of sales among sellers: those who would be willing to sell the good at the lowest price are not always those who actually manage to sell it.
Price floors often lead to inefficiency in that goods of inefficiently high quality are offered: sellers offer high-quality goods at a high price, even though buyers would prefer a lower quality at a lower price. 55

56. Evaluating Price Controls
Recall one of the Ten Principles from Chapter 1: Markets are usually a good way to organize economic activity.
Prices are the signals that guide the allocation of society’s resources. This allocation is altered when policymakers restrict prices.
Price controls often intended to help the poor, but often hurt more than help.
RE: the last bullet “price controls often hurt the poor more than help them.” We have seen that the minimum wage can cause job losses, and rent control can reduce the quantity and quality of affordable housing. Both policies make the poor worse off.
It might be worth reminding students that our analysis has been in the context of a world without market failures. Subsequent chapters (except in the macro split) will introduce situations in which government intervention can improve on the private market outcome. However, even in such cases, the appropriate policy is usually something other than a direct price control.
SUPPLY, DEMAND, AND GOVERNMENT POLICIES 56

57. CHAPTER SUMMARY
A tax on a good reduces the welfare of buyers and sellers. This welfare loss usually exceeds the revenue the tax raises for the govt.
The fall in total surplus (consumer surplus, producer surplus, and tax revenue) is called the deadweight loss (DWL) of the tax.
A tax has a DWL because it causes consumers to buy less and producers to sell less, thus shrinking the market below the level that maximizes total surplus. 57

58. CHAPTER SUMMARY
The price elasticities of demand and supply measure how much buyers and sellers respond to price changes. Therefore, higher elasticities imply higher DWLs.
An increase in the size of a tax causes the DWL to rise even more.
An increase in the size of a tax causes revenue to rise at first, but eventually revenue falls because the tax reduces the size of the market. 58

59. CHAPTER SUMMARY
A price ceiling is a legal maximum on the price of a good. An example is rent control. If the price ceiling is below the eq’m price, it is binding and causes a shortage.
A price floor is a legal minimum on the price of a good. An example is the minimum wage. If the price floor is above the eq’m price, it is binding and causes a surplus. The labor surplus caused by the minimum wage is unemployment. 59