Summary
Price Controls (Ceilings and Floors)
- 1. Even when a market is efficient, governments often intervene to pursue greater fairness or to please a powerful interest group. Interventions can take the form of price controls or quantity controls, both of which generate predictable and undesirable side effects, consisting of various forms of inefficiency and illegal activity.
- 2. A price ceiling, a maximum market price below the equilibrium price, benefits successful buyers but creates persistent shortages. Because the price is maintained below the equilibrium price, the quantity demanded is increased and the quantity supplied is decreased compared to the equilibrium quantity. This leads to predictable problems including inefficient allocation to consumers, wasted resources, and inefficiently low quality. It also encourages illegal activity as people turn to black markets to get the good. Because of these problems, price ceilings have generally lost favor as an economic policy tool. But some governments continue to impose them either because they don’t understand the effects or because the price ceilings benefit some influential group.
- 3. A price floor, a minimum market price above the equilibrium price, benefits successful sellers but creates a persistent surplus: because the price is maintained above the equilibrium price, the quantity demanded is decreased and the quantity supplied is increased compared to the equilibrium quantity. This leads to predictable problems: inefficiencies in the form of inefficient allocation of sales among sellers, wasted resources, and inefficiently high quality. It also encourages illegal activity such as black markets. The most well known kind of price floor is the minimum wage, but price floors are also commonly applied to agricultural products.
Quantity Controls (Quotas)
- 4. Quantity controls, or quotas, limit the quantity of a good that can be bought or sold. The government issues licenses to individuals, the right to sell a given quantity of the good. The owner of a license earns a quota rent, earnings that accrue from ownership of the right to sell the good. It is equal to the difference between the demand price at the quota amount, what consumers are willing to pay for that amount, and the supply price at the quota amount, what suppliers are willing to accept for that amount. Economists say that a quota drives a wedge between the demand price and the supply price; this wedge is equal to the quota rent. By limiting mutually beneficial transactions, quantity controls generate inefficiency. Like price controls, quantity controls lead to deadweight loss and encourage illegal activity.
Taxes
- 5. A tax that rises more than in proportion to income is a progressive tax. A tax that rises less than in proportion to income is a regressive tax. A tax that rises in proportion to income is, you guessed it, a proportional tax.
- 6. An excise tax—a tax on the purchase or sale of a good—raises the price paid by consumers and reduces the price received by producers, driving a wedge between the two. The incidence of the tax—how the burden of the tax is divided between consumers and producers—does not depend on who officially pays the tax.
- 7. The incidence of an excise tax depends on the price elasticities of supply and demand. If the price elasticity of demand is higher than the price elasticity of supply, the tax falls mainly on producers; if the price elasticity of supply is higher than the price elasticity of demand, the tax falls mainly on consumers.
- 8. The tax revenue generated by a tax depends on the tax rate and on the number of units sold with the tax. Excise taxes cause inefficiency in the form of deadweight loss because they discourage some mutually beneficial transactions. Taxes also impose administrative costs: resources used to collect the tax, to pay it (over and above the amount of the tax), and to evade it.
- 9. An excise tax generates revenue for the government but lowers total surplus. The loss in total surplus exceeds the tax revenue, resulting in a deadweight loss to society. This deadweight loss is represented by a triangle, the area of which equals the value of the transactions discouraged by the tax. The greater the elasticity of demand or supply, or both, the larger the deadweight loss from a tax. If either demand or supply is perfectly inelastic, there is no deadweight loss from a tax.
- 10. A lump-sum tax is a tax of a fixed amount paid by all taxpayers. Because a lump-sum tax does not depend on the behavior of taxpayers, it does not discourage mutually beneficial transactions and therefore causes no deadweight loss.