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```					ECN502: MICROECONOMICS I

LECTURE 1

MARKETS IN ACTION

YASHNEETA ARYA TRIMESTER 1 2011   1
Lecture Outline

     Housing markets and rent ceilings
     The labour market and the minimum wage
     Taxes
     Production Quotas
     Markets for illegal goods
     Markets and the distribution of gains and
losses

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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?
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. YASHNEETA ARYA TRIMESTER 1 2011   3
A HOUSING MARKET AFTER A CYCLONE
Figure 6.1(a)

SSA       After the Flood

900
Rent (dollars per unit per month)

SS

700

500                                               LS

D

0   20     30        40           60
Quantity (thousands of units per month)
YASHNEETA ARYA TRIMESTER 1 2011
A HOUSING MARKET AFTER A
CYCLONE       Figure 6.1(b)

SSa

900
Rent (dollars per unit per month)

SS

700

500                                                LS

D

0   20     30        40           60
Quantity (thousands of units per month)
YASHNEETA ARYA TRIMESTER 1 2011
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.

YASHNEETA ARYA TRIMESTER 1 2011   6
A RENT CEILING
Maximum black                              Figure 6.2
market rent
Rent (dollars per unit per month)                                                 SSA
900

700

Rent ceiling
500

Housing
shortage                        D

0    20          30            40
Quantity (thousands of units per month)
YASHNEETA ARYA TRIMESTER 1 2011
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.

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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.
YASHNEETA ARYA TRIMESTER 1 2011   9
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.

YASHNEETA ARYA TRIMESTER 1 2011   10
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.
YASHNEETA ARYA TRIMESTER 1 2011   11
A MARKET FOR LOW-SKILLED LABOUR
Figure 6.4(a)
Wage Rate (dollars per hour)       After Intervention

6                                            SS

5                                                 LS

4
D

3

DA

20          21        22         23
Quantity (millions of hours per year)
YASHNEETA ARYA TRIMESTER 1 2011
A MARKET FOR LOW-SKILLED
Figure 6.4(b)

6                                           SS
Wage Rate (dollars per hour)

5                                                   LS

4
D

3

DA

20          21          22             23
Quantity (millions of hours per year)
YASHNEETA ARYA TRIMESTER 1 2011
THE LABOUR MARKET AND THE MINIMUM WAGE

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.

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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.

YASHNEETA ARYA TRIMESTER 1 2011   15
Figure 6.5
MINIMUM WAGE AND UNEMPLOYMENT
Wage Rate (dollars per hour)

6                                              SS
Unemployment

5
A                              B           Minimum
wage
4

3
DA

20          21        22         23
Quantity (millions of hours per year)
YASHNEETA ARYA TRIMESTER 1 2011
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.

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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.
YASHNEETA ARYA TRIMESTER 1 2011    18
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.

YASHNEETA ARYA TRIMESTER 1 2011   19
A TAX ON SELLERS                                                                                Figure 6.7

5.00   Price paid                                S + tax on sellers
\$1.50 tax

4.00                                                       S
Price (dollars per packet)

Price with
no tax
3.00

2.50
2.00
by sellers                                    D
1.00

0           50      75     100     125 150           175 200 225
Quantity (millions of packets per year)
YASHNEETA ARYA TRIMESTER 1 2011
TAXES

•   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.

YASHNEETA ARYA TRIMESTER 1 2011   21
A TAX ON BUYERS                                                                                 Figure 6.8

5.00   Price paid
S
4.00
Price (dollars per packet)

Price with
no tax
3.00
\$1.50 tax
2.50
2.00
by sellers                                  D
1.00

50      75     100     125 150         175 200 225
0
Quantity (millions of packets per year)
YASHNEETA ARYA TRIMESTER 1 2011
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.

YASHNEETA ARYA TRIMESTER 1 2011   23
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

YASHNEETA ARYA TRIMESTER 1 2011   24
TAX AND THE                                                                         Figure 6.9(a)
ELASTICITY OF DEMAND
S + tax
entire tax
Price (dollars per dose)

2.20                                            S

Perfectly Inelastic
2.00
Demand

D

100
Quantity (thousands of doses per day)
YASHNEETA ARYA TRIMESTER 1 2011
TAX AND THE
ELASTICITY OF DEMAND                                                           Figure 6.9(b)
S + tax           S

1.00

Perfectly Elastic
Price (cents per pen)

Seller
pays
Demand
entire
tax
0.90

1                      4

Quantity (thousands of marker pens per week)
YASHNEETA ARYA TRIMESTER 1 2011
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
   The more inelastic the demand, the more the

YASHNEETA ARYA TRIMESTER 1 2011   27
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

YASHNEETA ARYA TRIMESTER 1 2011   28
TAX AND THE                                                                      Figure 6.10(a)
S
ELASTICITY OF SUPPLY
Price (cents per bottle)

Perfectly Inelastic
50
Supply
Seller pays
entire tax

45

D

100
Quantity (thousands of bottles per week)
YASHNEETA ARYA TRIMESTER 1 2011
TAX AND THE                 Figure 6.10(b)

ELASTICITY OF SUPPLY Perfectly Elastic
Price (cents per kilogram)

Supply
11                                        S + tax
entire tax

10                                          S

D

3         5
Quantity (thousands of kilograms per week)
YASHNEETA ARYA TRIMESTER 1 2011
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
   The more elastic the supply, the larger is the
amount of tax paid by the buyer.

YASHNEETA ARYA TRIMESTER 1 2011   31
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.

YASHNEETA ARYA TRIMESTER 1 2011   32
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

YASHNEETA ARYA TRIMESTER 1 2011   33
Figure 6.11
EFFICIENCYS + tax
TAXES AND Consumer
130
Price (dollars per player)

surplus
S

105
95                                      loss

75     Producer                                 D
surplus

0   1 2   3 4 5 6 7 8 9 10
Quantity (thousands of CD players per week)
YASHNEETA ARYA TRIMESTER 1 2011
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
marginal cost of producing the quota.
   Inefficiency of a quota
 A production quota is inefficient because it
results in underproduction.

YASHNEETA ARYA TRIMESTER 1 2011   35
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

YASHNEETA ARYA TRIMESTER 1 2011   36
A MARKET FOR AN ILLEGAL                                                 Figure 6.12
S + CBL
GOOD …to
P     B
Cost per unit
of breaking
J

F                        S

H
Price

PC                                               E

G
D
…to
seller
PS
K
D - CBL

QP                    QC

YASHNEETA ARYA TRIMESTER 1 2011
Quantity
A MARKET FOR ILLEGAL DRUGS

A market for illegal drugs:
• Penalties on sellers
• Penalties on both buyers and sellers

YASHNEETA ARYA TRIMESTER 1 2011   38
LEGALISING AND TAXING DRUGS

   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.

YASHNEETA ARYA TRIMESTER 1 2011   39

   Imports are the goods and services that we buy
from people in other countries.
   Exports are the goods and services we sell to
people in other countries.

YASHNEETA ARYA TRIMESTER 1 2011   40

•   Comparative advantage is the fundamental
force that generates trade between nations.
•   The basis for comparative trade is divergent
opportunity costs between countries.
•   Nations can increase the consumption of
goods and services—when they allocate
resources to the production of the goods and
services for which they have a comparative
YASHNEETA ARYA TRIMESTER 1 2011   41

•   A country has a comparative advantage in
producing a good if it can produce that good at a
lower opportunity cost than any other country.

YASHNEETA ARYA TRIMESTER 1 2011   42

Cheaper to buy than to produce
•   If it costs 500 tonnes of coal to produce a car in
Australia , while that same amount of coal costs
2.5 cars in the rest of the world, it makes sense for
the rest of the world to buy coal from Australia
and for Australians to buy cars from the rest of the
world.

YASHNEETA ARYA TRIMESTER 1 2011   43

Consumption possibilities
•   A country’s consumption possibilities frontier is
the limit to what its citizens can consume.
•   The consumption possibilities frontier is a
boundary that separates attainable consumption
levels from unattainable consumption levels.
•   With international trade an economy can consume
quantities of goods and services that differ from
those that it produces.

YASHNEETA ARYA TRIMESTER 1 2011   44

•Gains from trade occur in the real global
economy:
household goods from China, and TV sets and
DVD players from South Korea and Taiwan. In
exchange Australia sell food, energy and services
to these countries.

YASHNEETA ARYA TRIMESTER 1 2011   45

• Australia imports and at the same time
exports cars. Australia has a comparative
advantage in the production of some type of
cars and not in other types.
Diversity of taste and economies of scale
• People have a large diversity of taste and
there are economies of scale from producing
a large quantity of each variety of a good.

YASHNEETA ARYA TRIMESTER 1 2011   46
MARKETS AND THE DISTRIBUTION OF
GAINS AND LOSSES

Winners and losers in an import market
• By    comparing consumer surplus and
producer surplus with imports and without
imports, as shown in Fig 7.4, consumers gain
and producers lose.

YASHNEETA ARYA TRIMESTER 1 2011   47
Figure 7.4(b)
GAINS AND LOSSES IN A MARKET WITH IMPORTS
35
Gains and losses
Price (thousand of dollars per car)
from imports
Consumer
30                   Surplus
expands
SA
25

Increase in
20                                       total surplus
from imports
15                                                          World Price
DA

10       Producer
Surplus
shrinks
0         0.5          1.0        1.5
Quantity (millions of cars per year)
MARKETS AND THE DISTRIBUTION OF
GAINS AND LOSSES

Winners and losers in an export market
• We can see who gains and who loses by
looking at the changes to consumer surplus
and producer surplus.
• Consumer surplus remains the same while
producer surplus increases.
• Producers gain because they receive higher
price, sell more and receive a larger producer
surplus.

YASHNEETA ARYA TRIMESTER 1 2011   49
Figure 7.6(b)
GAINS AND LOSSES IN A MARKET WITH EXPORTS
125                  Consumer surplus can increase
decrease, or remain the same          The gains and losses
- here it remains the same
from export
100                          Increase in total surplus
From exports = D+E+F
Price (dollars per tonne)

A          F                                     SA
75                                                               World Price
D             E
B
50
40
C

25
Producer
Surplus                 DA
DA
expands

0                      100           200       300
Quantity (millions of tonnes per year)

protect domestic producers from competition
by using three main tools:
1.   Tariffs
2.   Subsidies
3.   Quotas

YASHNEETA ARYA TRIMESTER 1 2011   51

•   A tariff is a tax that is imposed by the importing
country when an imported good crosses its
international boundary.
   A subsidy is a payment made by a government to
a domestic producer based on the quantity
produced.
   A quota is a limit on the quantity of a good that
may be imported.

YASHNEETA ARYA TRIMESTER 1 2011   52
END OF LECTURE

THANK YOU FOR YOUR
ATTENTION

YASHNEETA ARYA TRIMESTER 1 2011   53

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