1. Chapter 6:
Markets in Action

2. Objectives After studying this chapter, you will be able to:
Explain how housing markets work and how price ceilings create housing shortages and inefficiency.
Explain how labour markets work and how minimum wage laws create unemployment and inefficiency.
Explain the effects of a tax.
Explain the effects of a production quota
Explain how markets for illegal goods work.

3. Housing Markets and Rent Ceilings
Imagine that a tropical cyclone makes landfall at Townsville and that floods destroy 50 per cent of the city’s homes
How would the Townsville housing market cope with such a devastating reduction in the supply of housing?

4. Housing Markets and Rent Ceilings
The housing market before and after a flood
Figure 6.1 shows the market for housing in Townsville before and after a massive tropical storm floods the city.
D is the demand curve for housing. SS is the short run supply curve and LS the long run supply curve after the market responds to a change in price after enough time has elapsed
Time and the elasticity of supply. Get the students to recall the different influences on the supply elasticity of the firm from Chapter 4 and remind them how the luxury of time allows sellers to fully respond to changes in their environment.
Explain why it is likely that supply is perfectly elastic in the long run for many goods and services.

5. A Housing Market After a Cyclone
Figure 6.1(a)
SSA
After the Flood
900 SS
700
Rent (dollars per unit per month)
500 LS D
Quantity (thousands of units per month)

6. A Housing Market After a Cyclone
Figure 6.1(b)
SSa
900 SS
700
Long-run adjustment
Rent (dollars per unit per month)
500 LS D
Quantity (thousands of units per month)

7. Housing Markets and Rent Ceilings
A regulated housing market
A price ceiling is a regulation that makes it illegal to charge a price higher than a specified level.
When a price ceiling is applied to a housing market, it is called a rent ceiling.
If the rent ceiling is set above the equilibrium rent, it has no effect. The market works as if there were no ceiling.
But if the rent ceiling is set below the equilibrium rent, it has powerful effects.

8. A Rent Ceiling Maximum black market rent SSA Rent ceiling D
Figure 6.2
Maximum black market rent
Rent ceiling
SSA
900
700
Rent (dollars per unit per month)
500
Housing
shortage D
Quantity (thousands of units per month)

9. Housing Markets and Rent Ceilings
Search activity
The time spent looking for someone with whom to do business is called search activity.
When a price is regulated and there is a shortage, search activity increases.
Search activity is costly. It uses time and other resources
A rent ceiling controls the rent portion of the cost of housing, but it does not control the opportunity cost, which might even be higher than the rent in the unregulated market.

10. Housing Markets and Rent Ceilings
Black markets
A black market is an illegal market in which the price exceeds the legally imposed price ceiling
A shortage of housing creates a black market in housing.
Illegal arrangements are made between renters and landlords at rents above the rent ceiling—and generally above what the rent would have been in an unregulated market.

11. Housing Markets and Rent Ceilings
Inefficiency of rent ceilings
A rent ceiling leads to an inefficient use of resources.
The quantity of rental housing is less than the efficient quantity and there is a deadweight loss.
A rent ceiling is also, usually, unfair.
It does not generally benefit the poor.
It creates an even bigger problem for the housing market.

12. The Labour Market and the Minimum Wage
New labour-saving technologies become available every year, which mainly replace low-skilled labour.
Does the persistent decrease in the demand for low-skilled labour depress the wage rates of these workers?
The immediate effect of these technological advances is a decrease in the demand for low-skill labour, a fall in the wage rate, and a decrease in the quantity of labour supplied.
Figure 6.4 on the next slide illustrates this immediate effect.
Labour is work that households supply and firms demand. You might be surprised to find that quite a few students think that the demand for labour is the demand by a household for a job, and the supply of labour is the supply of jobs by firms. Of course, they get into a big mess with this mirror image view of the labour market. Try to avoid this all-too-common mistake by being very explicit that labour is work. Households supply it and firms demand it. Sure, firms provide jobs and people want jobs to earn an income. But it is labour, not jobs, that is supplied and demanded in the labour market.

13. A Market for Low-Skilled Labour
Figure 6.4(a) DA
After Intervention 6 SS
Wage Rate (dollars per hour) LS 5 4 D
Instructor Notes:
The wage rate falls to $4 an hour, and employment decreases to 21 million hours a year. 3
Quantity (millions of hours per year) 33

14. A Market for Low-Skilled Labor
SSA
Long Run Adjustment
Figure 6.4(b) 6 SS LS 5
Wage Rate (dollars per hour) 4 D
Instructor Notes:
In the long run, the wage rate returns to $5 an hour, and employment falls to 20 million hours a year. 3 DA
Quantity (millions of hours per year) 35

15. The Labour Market and the Minimum Wage
A price floor is a regulation that makes it illegal to trade at a price lower than a specified level.
When a price floor is applied to labour markets, it is called a minimum wage.
If the minimum wage is set below the equilibrium wage rate, it has no effect. The market works as if there were no minimum wage.
If the minimum wage is set above the equilibrium wage rate, it has powerful effects.

16. The Labour Market and the Minimum Wage
If the minimum wage is set above the equilibrium wage rate, the quantity of labour supplied by workers exceeds the quantity demanded by employers. There is a surplus of labour.
Because employers cannot be forced to hire a greater quantity than they wish, the quantity of labour hired at the minimum wage is less than the quantity that would be hired in an unregulated labour market.
Because the legal wage rate cannot eliminate the surplus, the minimum wage creates unemployment
Figure 6.5 on the next slide illustrates these effects.

17. Minimum Wage and Unemployment
Figure 6.5 6 SS A B
Unemployment
Wage Rate (dollars per hour) 5
Minimum
wage 4 3 DA
Quantity (millions of hours per year) 38

18. The Labour Market and the Minimum Wage
Inefficiency of the minimum wage
The minimum wage is inefficient.
Unemployed workers are willing to work for less than the minimum wage, and firms are willing to hire them for less than the minimum wage.
The minimum wage law frustrates these transactions that would benefit both workers and the firms that hire them.

19. Australia’s Wage Regulation and Its Effects
The Commonwealth Arbitration Court established the minimum wage, or basic wage, in 1907
Historically, minimum wage were awarded to provide families with a living wage and to ensure ‘fair comparability among other occupations
A living wage is defined as an hourly wage rate that enables a person who works a 38 hour work week to provide a family with adequate housing for not more than 3 per cent of the amount earned

20. Australia’s Wage Regulation and Its Effects
Reforms of the 1990s and 2000s
The Reform Act of 1993, the Workplace Relations Act of 1996, and Workchoices Act of 2005 were designed to make the labour market more competitive and wage rates more responsive to productivity
Studies of the effects of the minimum wage by the Australian Productivity Commission has concluded that large changes in minimum wages do affect employment

21. Taxes
Tax incidence
Tax incidence is the division of the burden of a tax between the buyer and the seller
When a tax is imposed, the price paid by the buyer may rise by the full amount of the tax, by a lesser amount, or not at all.
If the price rises by the full amount the buyer pays the tax
If the price rises by a lesser amount, the tax is shared between the buyer and the seller.
If the price did not change, the burden of the tax falls entirely on the seller.

22. Taxes
A tax on sellers
A tax on sellers is like an increase in costs, 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.

23. A Tax on Sellers S + tax on sellers S Price (dollars per packet) D
Figure 6.7
S + tax on sellers
5.00
4.00
3.00
1.00
Price paid
by buyers
$1.50 tax S
Price with
no tax
Price (dollars per packet)
Price received
by sellers D
Quantity (millions of packets per year)

24. Taxes
A tax on buyers
A tax on buyers will decrease demand and the demand curve shifts leftwards.
To find the new demand curve, the tax is subtracted from the maximum price that buyers are willing to pay for each quantity bought.

25. A Tax on Buyers S Price (dollars per packet) D D - tax on buyers
Figure 6.8
5.00
4.00
3.00
2.50
2.00
1.50
1.00
Price paid
by buyers S
D - tax on buyers
Price with
no tax
$1.50 tax
Price (dollars per packet)
Price received
by sellers D
Quantity (millions of packets per year)

26. Taxes Equivalence of tax on buyers and sellers
Tax on buyers has the same effects as the tax on sellers
In both cases the equilibrium quantity decreases by the same amount
A tax is like a wedge between the buying price and the selling price, It is the size of the wedge, not the side of the market on which the tax is imposed by the government, that determines the effects of the tax.

27. Tax Division and Elasticity of Demand
The division of the tax burden between buyer and seller depends in part on the elasticity of demand.
Two extremes:
Perfectly elastic demand: buyer pays
Perfectly inelastic demand: seller pays

28. Tax and the Elasticity of Demand
Figure 6.9(a)
S + tax
Buyer pays
entire tax S
2.20
Price (dollars per dose)
Perfectly Inelastic
Demand
2.00 D
100
Quantity (thousands of doses per day) 46

29. Tax and the Elasticity of Demand
Figure 6.9(b)
S + tax S
1.00
Seller
pays
entire
tax
Perfectly Elastic
Demand
Price (cents per pen)
0.90
Quantity (thousands of marker pens per week) 48

30. Tax Division and Elasticity of Demand
In the usual case, demand is neither perfectly inelastic nor perfectly elastic.
This means that the tax is generally split between buyer and seller.
The more inelastic the demand, the more the buyer pays.

31. Tax Division and Elasticity of Supply
The division of the tax burden between the buyer and the seller also depends, in part, on the elasticity of supply.
Two extreme cases:
Perfectly inelastic supply: seller pays
Perfectly elastic supply: buyer pays

32. Tax and the Elasticity of Supply
Figure 6.10(a) S
Perfectly Inelastic
Supply
Price (cents per bottle) 50
Seller pays
entire tax 45
Instructor Notes:
1) With a sales tax of 5 cents a bottle, the price remains at 50 cents a bottle.
2) The number of bottles bought remains the same, but the price received by the seller decreases to 45 cents a bottle.
3) The spring produces 100,000 bottles of water per week regardless of the price.
4) Buyers will buy the 100,000 bottles only if the price is 50 cents.
5) The seller pays the entire tax. D
100
Quantity (thousands of bottles per week) 52

33. Tax and the Elasticity of Supply
Figure 6.10(b)
S + tax
Perfectly Elastic
Supply
Price (cents per kilogram) 11
Buyers pays
entire tax 10 S
Instructor Notes:
1) The Excise Tax of 1 cent a kilogram increases the minimum supply price to 11 cents a kilogram.
2) The supply curve shifts to S + tax.
3) The price increases to 11 cents a kilogram.
4) The buyer pays the entire tax.
5) As a result the buyer purchases less. D
Quantity (thousands of kilograms per week) 54

34. Tax Division and Elasticity of Supply
In the usual case, supply is neither perfectly inelastic nor perfectly elastic.
This means that the tax is generally split between buyer and seller.
The more elastic the supply, the larger is the amount of tax paid by the buyer.

35. Taxes in Practice
Sales tax is generally applied to items with a low elasticity of demand (alcohol, tobacco, and petrol).
Quantity does not decrease by much, so government collects a large tax revenue
It is unusual to apply sales tax to goods with a high elasticity of demand—tax revenue will be small.
Labour has a low elasticity of supply and a high elasticity of demand. Any tax applied to labour falls mainly on workers.

36. Taxes and Efficiency
Sales taxes place a wedge between the buyers’ price and the sellers’ price.
The marginal benefit of the buyer does not equal the marginal cost of the seller. This creates inefficiency.
The more inelastic is demand or supply, the smaller the decrease in quantity and so also the smaller the deadweight loss.

37. Taxes and Efficiency 130 S + tax S + tax S S
Figure 6.11
130
S + tax
S + tax
Consumer
surplus S S
Price (dollars per player)
105
Tax Revenue
Deadweight
loss
100 95
Producer
surplus
Instructor Notes:
A deadweight loss also arises, which is shown by the gray area. 75 D D
Quantity (thousands of CD players per week) 62

38. Production Quotas
A production quota is an upper limit to the quantity of a good or service that may be produced in a specified period
Effects of quota
A quota raises the price, and also lowers the the marginal cost of producing the quota.
Inefficiency of a quota
A production quota is inefficient because it results in underproduction

39. Markets for Illegal Goods
When a good is illegal, the cost of trading in the good increases.
Penalties and policing increase the cost.
Decreases supply and/or demand 64

40. A Market for an Illegal Good
Figure 6.12
S + CBL F
Cost per unit
of breaking
the law...
…to
seller J PB
…to
buyer S G
D - CBL H
Price PC E D PS K
Q P QC
Quantity 69

41. A Market for Illegal Drugs
Penalties on sellers
Penalties on buyer
Penalties on both buyers and sellers 70

42. Legalising and Taxing Drugs
Illegal trading to evade the tax
Some pros and cons of taxes versus prohibition.
Tax revenue can be used to make law enforcement more effective
Tax revenue can be used to run a more effective education campaign against drugs
Prohibition will decrease the demand for drugs

43. END
CHAPTER 6