Price controls - gov. mandated prices. Gov. thinks price is
too high or too low.
1. Price ceilings - a legally established maximum price that sellers
Example 1 - Some rental markets, like New York City, set a maximum price
that landlords can charge for apartment rent.
- The market price is P* and quantity is Q*. Gov. thinks rent is too expensive,
and sets price at P~.
- Market rent price > Rent controlled price:
- Direct effect (When P* > P~).
- Quantity demanded (Qd) > quantity supplied (Qs).
- Secondary effects of price ceilings.
- Long waiting lists.
- "Under the table" payments to
- Tenants has to buy expensive furniture from landlord.
- Investors do not invest in new housing, because market rents are
too low to make a profit.
- The quality of housing will deteriorate.
- Landlords lower costs by less maintenance and repairs.
||A very good trick question on the exam.
> P*, then the price control has no effect on the market.
2. Price Floor - a legally established minimum price that buyers
Example 2 - Government requires employers to pay a minimum wage.
|Labor Market (Unskilled workers)
- Gov. thinks workers' wages are too low and
set the wage rate to $5.30 per hour (P~).
- Employers demand workers, while employees
- The wage is the price of labor.
- Direct effect (When P~> P*).
- Quantity supplied (Qs) > quantity demanded (
- Surplus of labor, i.e.
- Secondary effects
- Employer reduces
- Health insurance.
- Job training.
- Pension plans.
- Usually hurts unskilled labor, the poor,
||If P* >
P~, then the price control has no effect on the market
tend to pay more than minimum wage.
- Tax incidence - how the "economic" burden of tax is
shared between buyers and sellers.
- Statutory incidence of
tax - the legal assignment of who
pays a tax
- Who sends the taxes to the gov.
- Tax incidence and statutory incidences
- Example: Gov. places a $1 tax on each
pizza sold on pizza producers.
- Statutory incidence falls on producers.
- Tax rate
- the per-unit tax
- Taxes are usually a percentage; this changes the slope of supply
- Supply curve shifts left by exactly $1.
- Market price was at P*, $10 per
does not equal $11.
- Price lies between $11 and $10.
- The tax changes consumer's behavior.
- Higher market price (price + tax), Pt.
- Consumers buy less, Qt.
- Tax base
- the total amount of goods, which are
- The higher the tax rates, the smaller the
- Changes consumers' and producers' behavior.
- Tax revenue from pizza = Qt X $1.
- (area of a rectangle width X height)
- blue area + yellow area.
- "Yellow area" - actual tax
burden on sellers.
- "Blue area"- actual tax
burden on buyers.
- Deadweight loss of
taxation - the red area.
- "Excess burden of taxation."
- Nobody receives this revenue.
- A loss to society, because gov. interfered
with the market.
- If the $1 pizza tax was placed on the buyer.
- (switching statutory incidence from sellers
- The buyer send the tax to the gov.
- The demand curve will shift to the left by
$1, but the end result is exactly the same!
- Statutory incidence of tax changed, but the
tax burden remained the same.
- Do not worry about elasticities! Using
elasticities of demand and supply, economists can predict which party
has the larger tax burden.
- Inelastic demand
(relative to supply) - quantity demanded is not
sensitive to price changes.
- Tax burden falls on consumers.
- Gov. loves to tax inelastic goods.
- Gasoline (short-run).
- Beer / liquor.
Average tax rate = tax liability / taxable income.
Ex: Salary is $20,000 and tax liability is $5,000.
average tax rate = $5,000 /
$20,000 X 100% = 25%
- Progressive tax rate - average tax rate rises with income.
- Proportional tax
- the average tax rate stays the same across all
- Kazakhstan - income tax is 20% of income
- Regressive tax
- the average tax rate falls with income, i.e.
higher income results in lower average tax rate.
Example 1 - U.S. Income taxes are progressive - low-income
households pay small average tax rates, while high-income households pay higher tax rates.
Example 2 - Sales tax on food. 2
families each spend $10,000 on food per year. Sales tax is 7%, so $700 is collected
from each family per year.
income = $50,000 F
2nd family's income
= $20,000 F
F Sales tax tends to be a regressive tax.
tax rate = D
tax liability / D
Ex: If marginal tax rate = 28% and
family income increases by $100, then tax liability increases by $28. The tax
increase affects household decisions to work, save, leisure, etc.
Laffer Curve - shows relationship between tax rates and tax revenues.
- Two points:
- 0% tax rate = 0 tax revenue
- 100 % tax rate = 0 tax revenue
- Nobody would legally work; government takes all income
- As the tax rate increases, the tax base
decreases (the activity being taxed),
- Tax changes behavior.
- Deadweight loss increases.
- Example: - Refer to Laffer Curve diagram below.
- The tax rate is 50% and the gov. wants to increase tax revenue.
- If the tax rate is increased, tax revenue
- If tax rate is lowered, then tax revenue
- Nobody knows the shape of these curves!!!
- Basis of Reaganomics.
- President Ronald Reagan lowered tax rates during 1980s.
- During the 1980s, the top marginal income
tax rate fell from 70% to 33% (the average tax rates for the "rich"
- Between 1980 and 1990 real income tax
revenue collected from the top 1 % of earners rose a whopping 51.4 %.
Black markets –
markets that operate outside of the legal system
Also called the
shadow or hidden economy
products or services
Avoid high taxes
Use barter –
internet allows people to find each other
Money is not
exchanged, thus value of transaction is zero for tax purposes
controls and costly regulations
Decline in civil
loyalty to gov.
respect for gov.
people pay taxes, etc.
have supply/demand functions
between legitimate and black markets
risk, such as arrest, fines/fees, and/or prisons/jails
violence in enforcing contracts
revenue – gov. cannot invest in infrastructure, education, etc.
Unemployment rate is higher than actual
will lie and say they are not working
Size of black
Appear to be
growing in many countries
thrive in highly taxed, highly regulated economies.
Size of Hidden Economy for Several Countries
Size of Hidden Economy
1990 – 1993
|% of Real GDP
||68 to 76%
||40 to 60%
||20 to 27%
||8 to 10%
||8 to 10%
Source: Schneider and Enste (2000)
How to fix black
As size of black
markets decrease, then corruption will decrease too