Week 6: Government Actions in Markets

Question 1

What is a price ceiling?

Answer 1

A government regulation that establishes a legal maximum price for a good or service

Question 2

What is a rent ceiling?

Answer 2

A price ceiling applied to the housing market

Question 3

What are the effects of a price ceiling if it is set above equilibrium price?

Answer 3

It’s a non-binding constraint so it’s ineffective.

Question 4

What are the effects of a price ceiling if it is set below equilibrium price?

Answer 4

It’s a binding constraint that results in a shortage, increased search activity, and black market trading.

Question 5

What is search activity?

Answer 5

It’s the time, effort, and resources spent looking for someone to buy from.

Question 6

What is a black market?

Answer 6

An illegal market in which the equilibrium price exceeds the price ceiling (trading illegally at a price above the ceiling).

Question 7

How are scarce housing resources allocated when a rent ceiling is in place?

Answer 7

Methods other than the market price (e.g. lottery, first-come, first-served, discrimination)

Question 8

Why does a rent ceiling create an inefficient and unfair outcome in the housing market?

Answer 8

Inefficient: A rent ceiling set below equilibrium rent results in inefficient underproduction (shortage), so the marginal social benefit exceeds the marginal social cost. This results in a deadweight loss and shrinks the consumer and producer surplus.
Unfair: Housing isn’t allocated to the poor.

Question 9

What is a price floor?

Answer 9

A government regulation that establishes a legal minimum price for a good or service

Question 10

What is a minimum wage?

Answer 10

A price floor applied to the labour market

Question 11

What are the effects if a price floor is set above the equilibrium price?

Answer 11

It’s a binding constraint that results in a surplus (unemployment) and increased search activity.

Question 12

How are scare jobs allocated when a minimum wage is in place?

Answer 12

Other mechanisms other than the wage rate are used such as discrimination.

Question 13

Why does a minimum wage create an inefficient allocation of labour resources?

Answer 13

At the quantity of labour employed, firm’s marginal social benefit exceeds worker’s marginal social cost and a deadweight loss shrinks the consumer surplus and producer surplus.

Question 14

Why is a minimum wage unfair?

Answer 14

Unfair result: Only those who have and keep their jobs benefit from the minimum wage. Others are worse off.
Unfair rules: There is no voluntary exchange.

Question 15

What is the equation for tax (T) in dollars per unit?

Answer 15

Difference between what consumers pay and what producers receive
T= Pc - Pp

Question 16

What is a consumer price?

Answer 16

Total amount paid by consumers including any tax paid

Question 17

What is a producer price?

Answer 17

Total amount received by producers net of any tax paid

Question 18

How does the elasticity of demand influence the incidence of a tax, the tax revenue, and the deadweight loss?

Answer 18

a) The more elastic the demand, the smaller the amount of tax paid by buyers, and the greater the amount of tax paid by sellers.
b) The more elastic the demand, the smaller the government tax revenue.
c) The more elastic the demand, the greater is the deadweight loss.

Question 19

How does the elasticity of supply influence the incidence of a tax, quantity bought, tax revenue, and deadweight loss?

Answer 19

a) The more elastic the supply, the smaller the amount of tax paid by sellers, and the greater the amount of tax paid by buyers.
b) The more elastic the supply, the greater the decrease in the quantity bought.
c) The more elastic the supply, the smaller the government tax revenue.
d) The more elastic the supply, the greater is the deadweight loss.

Question 20

Why is a tax inefficient?

Answer 20

Tax drives a wedge between what consumers pay and what producers receive, resulting in inefficient underproduction. Marginal social benefit exceeds marginal social costs, consumer and producers surplus shrink, and a deadweight loss is created.

Question 21

Why would a tax be efficient?

Answer 21

Tax is efficient when demand and supply are perfectly inelastic. It does not create a deadweight loss and the quantities bought and sold remain the same.

Question 22

What are the two principles of fairness that are applied to tax systems?

Answer 22

a) Benefit principle- people should pay taxes equal to the benefits they receive
b) Ability-to-pay principle- people should pay taxes according to how easily they can bear the burden of the tax

Question 23

What is the effect of a tax levied on producers?

Answer 23

It decreases market supply. Supply curve shifts leftward by the amount of the tax at every quantity.

Question 24

What is the effect of a tax levied on consumers?

Answer 24

It decreases market demand. Demand curve shifts leftward by the amount of the tax at every quantity.

Question 25

What is a production quota?

Answer 25

An upper limit to the total quantity of a good that may be produced

Question 26

What are the effects of a production quota on the market price and the quantity produced?

Answer 26

Below the equilibrium quantity:

a) Supply decreases so the market price increases.
b) Inefficient underproduction so MSB > MSC

Above the equilibrium quantity: inefficient

Question 27

Why is a production quota inefficient?

Answer 27

There is inefficient underproduction. Marginal social benefit exceeds marginal social cost (which decreases below market price).

Question 28

Why is a voluntary production quota difficult to operate?

Answer 28

It creates an incentive for producers to cheat and overproduce so they could get a larger profit. Monitoring and punishment systems are costly.

Question 29

What is a subsidy?

Answer 29

A payment made by the government to a producer

Question 30

What is the equation for subsidy (S) in dollars per unit?

Answer 30

Difference between what consumers pay and what producers receive
S= Pp - Pc

Question 31

What are the effects of a subsidy on the market price and the quantity produced?

Answer 31

Supply increases so the market price decreases and the quantity produced increases. Consumer surplus and producer surplus increases.

Question 32

Why is a subsidy inefficient?

Answer 32

There is inefficient overproduction. Marginal social cost increases above market price and exceeds marginal social benefit.

Question 33

What are the effects of a penalty for selling illegal drugs?

Answer 33

Supply decreases and a cost for breaking the law is added.

Question 34

What are the effects of a penalty for possessing illegal drugs?

Answer 34

Demand decreases. Cost of breaking the law is subtracted from the value of the good.