Government Actions in Markets: Price Controls, Taxes, Quotas, Subsidies, and Illegal Goods

Government Actions in Markets

Introduction

This chapter examines how government interventions such as price ceilings, price floors, taxes, production quotas, subsidies, and prohibitions affect market outcomes. These policies can lead to shortages, surpluses, inefficiencies, and unintended consequences in various markets.

A Housing Market with a Rent Ceiling

Price Ceilings and Rent Ceilings

• Price ceiling (price cap): A regulation that makes it illegal to charge a price higher than a specified level.

• Rent ceiling: A price ceiling applied to the housing market.

• If the rent ceiling is set above the equilibrium rent, it has no effect; the market operates as usual.

• If the rent ceiling is set below the equilibrium rent, it creates:

  • A housing shortage

  • Increased search activity

  • Illegal trading

Housing Shortage

• When the rent ceiling is below equilibrium, the quantity of housing demanded exceeds the quantity supplied, resulting in a shortage.

• Example: If equilibrium rent is $1,200/month and the ceiling is $1,000/month, the legal market cannot clear, and the equilibrium rent is in the illegal region.

Increased Search Activity

• Search activity: The time spent looking for someone with whom to do business.

• When shortages occur due to price regulation, search activity increases, raising the opportunity cost of housing (regulated rent + search cost).

• Opportunity cost of housing exceeds the unregulated rent due to the shortage.

Illegal Trading

• Rent ceilings can incentivize illegal trading, where renters pay above the legal ceiling to secure housing.

• Illegal markets may develop alongside legal ones, with deals at rents above the ceiling and often above unregulated market rents.

Inefficiency of a Rent Ceiling

• Rent ceilings below equilibrium lead to inefficient underproduction of housing services.

• Marginal social benefit from housing exceeds marginal social cost, creating a deadweight loss.

• Both consumer and producer surplus shrink, and increased search activity adds to the loss.

Fairness of Rent Ceilings

• Fair rules view: Rent ceilings are unfair because they block voluntary exchange.

• Fair results view: Rent ceilings are unfair because they do not generally benefit the poor.

• Scarce housing is allocated by lottery, first-come-first-served, or discrimination—none of which are considered fair outcomes.

A Labour Market with a Minimum Wage

Price Floors and Minimum Wage

• Price floor: A regulation that makes it illegal to trade at a price lower than a specified level.

• Minimum wage: A price floor applied to labour markets.

• If set below equilibrium wage, it has no effect; if set above, it has significant effects.

Minimum Wage and Unemployment

• If minimum wage is above equilibrium, the quantity of labour supplied exceeds the quantity demanded, creating a surplus of labour (unemployment).

• The quantity of labour hired is less than in an unregulated market.

• Example: If equilibrium wage is $14/hour and minimum wage is $15/hour, only the quantity demanded at $15 is employed, and the rest is unemployed.

Fairness and Inefficiency of Minimum Wage

• Minimum wage rates are set by provincial governments (e.g., $11.32/hour in Saskatchewan, $15/hour in Alberta as of June 2020).

• Most economists believe minimum wage laws increase unemployment among low-skilled, younger workers.

• Minimum wage leads to inefficient outcomes: less labour employed than efficient, deadweight loss, and reduced worker and firm surplus.

• Increased job search adds to the loss of surplus.

Taxes

Tax Incidence

• Tax incidence: The division of the burden of a tax between buyers and sellers.

• If the market price rises by the full amount of the tax, buyers pay the tax; if less, both share; if not at all, sellers pay the tax.

Equivalence of a Tax on Buyers and Sellers

• The effect of a tax is the same regardless of whether it is imposed on buyers or sellers.

• Example: A $6 tax on cigarettes can be imposed on either side, with the same market outcome.

Effects of a Tax

• A tax on sellers shifts the supply curve up by the amount of the tax; a tax on buyers shifts the demand curve down.

• The market price paid by buyers rises, the price received by sellers falls, and the quantity traded decreases.

• The tax acts as a wedge between the price buyers pay and the price sellers receive.

• The equilibrium quantity is where the vertical gap between supply and demand equals the tax.

Taxes and Efficiency

• Except in cases of perfectly inelastic demand or supply, taxes create inefficiency by reducing the quantity traded below the efficient level.

• Taxes reduce total surplus (consumer + producer surplus) and create a deadweight loss.

Tax Incidence and Elasticity

• The division of the tax burden depends on the elasticities of demand and supply:

  • Perfectly inelastic demand: buyers pay the entire tax.

  • Perfectly elastic demand: sellers pay the entire tax.

  • Perfectly inelastic supply: sellers pay the entire tax.

  • Perfectly elastic supply: buyers pay the entire tax.

  • The more inelastic side of the market bears a larger share of the tax.

Taxes in Practice

• Taxes are often levied on goods with inelastic demand (e.g., alcohol, tobacco, gasoline) or inelastic supply (e.g., labour).

• Buyers of inelastic goods pay most of the tax; workers pay most of the income and social security taxes due to low elasticity of labour supply.

Taxes and Fairness

• Benefits principle: People should pay taxes equal to the benefits they receive from government services.

• Ability-to-pay principle: People should pay taxes according to their ability to bear the burden; higher incomes justify higher tax rates.

Production Quotas and Subsidies

Production Quotas

• Production quota: An upper limit to the quantity of a good that may be produced during a specified period.

• Quotas decrease quantity produced, raise market price, and lower marginal cost.

• Production becomes inefficient, and producers may have an incentive to cheat.

Subsidies

• Subsidy: A payment made by the government to a producer.

• Subsidies increase supply, lower market price, and raise the quantity produced.

• Marginal cost rises above market price; overproduction occurs, leading to inefficiency.

Markets for Illegal Goods

Illegal Goods and Market Outcomes

• Prohibitions (e.g., on drugs) do not eliminate markets; illegal markets emerge.

• Penalties on sellers decrease supply, raising price and lowering quantity sold.

• Penalties on buyers decrease demand, lowering price and quantity sold.

• Penalties on both sides decrease both supply and demand, further reducing quantity traded.

• The opportunity cost of buying illegal goods includes both the market price and the risk of breaking the law.

• Legalizing and taxing illegal goods can achieve similar reductions in consumption as prohibition, depending on the tax rate.

Summary Table: Effects of Government Interventions

Policy	Market Effect	Efficiency	Equity/Fairness
Rent Ceiling (Price Ceiling)	Shortage, increased search, illegal trading	Inefficient (underproduction, deadweight loss)	Unfair (blocks exchange, does not benefit poor)
Minimum Wage (Price Floor)	Surplus of labour (unemployment)	Inefficient (deadweight loss, less employment)	Unfair (increases youth unemployment)
Tax	Decreased quantity, wedge between price paid and received	Inefficient (deadweight loss)	Depends on incidence and principles applied
Quota	Reduced quantity, higher price	Inefficient (underproduction)	May benefit producers, harms consumers
Subsidy	Increased quantity, lower price	Inefficient (overproduction)	May benefit producers, costly to government
Prohibition	Illegal market, higher prices, lower quantity	Inefficient (resources spent on evasion, enforcement)	Depends on social goals

Key Formulas

• Tax wedge: The vertical gap between supply and demand curves equals the size of the tax.

• Deadweight loss (DWL): The loss in total surplus due to market inefficiency (e.g., from taxes, quotas, or price controls).

Additional info: Deadweight loss can be calculated as the area of the triangle between the supply and demand curves at the quantity traded after intervention and the equilibrium quantity.