Government Actions in Markets: Rent Ceilings, Minimum Wage, Taxes, Quotas, Subsidies, and Illegal Goods

Government Actions in Markets

Introduction

This chapter explores how government interventions such as price ceilings, price floors, taxes, production quotas, subsidies, and regulations on illegal goods affect market outcomes. These policies can lead to shortages, surpluses, inefficiencies, and changes in fairness and equity within markets.

Rent Ceilings in the Housing Market

Price Ceilings and Rent Ceilings

A price ceiling (or price cap) is a regulation that makes it illegal to charge a price higher than a specified level. When applied to housing, it is called a rent ceiling.

• If the rent ceiling is set above the equilibrium rent, it has no effect.

• If set below the equilibrium rent, it creates:

  • 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 market rent moves into the illegal region.

Increased Search Activity

Search activity refers to the time spent looking for someone with whom to do business. When shortages occur due to regulation, search activity increases, raising the opportunity cost of housing above the regulated rent.

Illegal Trading

Rent ceilings can incentivize illegal trading, where renters pay above the legal ceiling. This often occurs alongside legal markets and can result in rents higher than those in unregulated markets.

Inefficiency of a Rent Ceiling

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

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

• Both consumer surplus and producer surplus shrink.

• Potential loss from increased search activity.

Fairness of Rent Ceilings

• Fair rules view: Unfair because it blocks voluntary exchange.

• Fair results view: Unfair because it does not generally benefit the poor.

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

Minimum Wage in the Labour Market

Price Floors and Minimum Wage

A price floor is a regulation that makes it illegal to trade at a price lower than a specified level. In labour markets, this is called a minimum wage.

• If set below equilibrium wage, it has no effect.

• If set above equilibrium wage, it creates unemployment.

Minimum Wage and Unemployment

• Quantity of labour supplied exceeds quantity demanded, creating a surplus (unemployment).

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

• Example: Equilibrium wage is $14/hour, minimum wage is $15/hour; only the quantity demanded is employed.

Fairness of Minimum Wage

• Set by provincial governments; rates vary by region.

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

Inefficiency of Minimum Wage

• Leads to inefficient outcomes: less labour employed than efficient quantity.

• Supply of labour = marginal social cost (leisure forgone).

• Demand for labour = marginal social benefit (value of goods produced).

• Deadweight loss arises; worker and firm surplus decrease; increased job search adds to loss.

Taxes

Tax Incidence

Tax incidence is the division of the burden of a tax between buyers and sellers.

• If price rises by full amount of tax, buyers pay the tax.

• If price rises by less than the tax, buyers and sellers share the burden.

• If price does not rise, sellers pay the tax.

Equivalence of Tax on Buyers and Sellers

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

• Example: Ontario cigarette tax—same market outcome whether taxed at production or sale.

Effects of a Tax

• Tax on sellers: Supply decreases, price paid by buyers rises, price received by sellers falls, quantity bought decreases.

• Tax on buyers: Demand decreases, same effect as tax on sellers.

• Tax acts as a wedge between buyer's price and seller's price.

Taxes and Efficiency

• Except for perfectly inelastic demand or supply, taxes create inefficiency.

• Market moves from efficient (marginal social benefit = marginal social cost) to inefficient (deadweight loss).

• Tax revenue takes part of total surplus; decreased quantity creates deadweight loss.

Tax Incidence and Elasticity

• Division of tax burden depends on elasticities of demand and supply.

• Perfectly inelastic demand: buyers pay entire tax.

• Perfectly elastic demand: sellers pay entire tax.

• Perfectly inelastic supply: sellers pay entire tax.

• Perfectly elastic supply: buyers pay entire tax.

• More inelastic side of market bears more of the tax burden.

Taxes in Practice

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

• Labour has low elasticity of supply; workers pay most income and social security taxes.

Taxes and Fairness

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

• Ability-to-pay principle: People should pay taxes according to how easily they can bear the burden.

Production Quotas and Subsidies

Production Quotas

A production quota is an upper limit to the quantity of a good that may be produced during a specified period.

• Quota reduces quantity produced, increases price, decreases marginal cost.

• Leads to inefficient production and incentives to cheat.

Subsidies

A subsidy is a payment made by the government to a producer.

• Subsidy increases supply, lowers market price, increases quantity produced.

• Marginal cost rises above market price; producers receive market price plus subsidy.

• Leads to inefficient overproduction (marginal social cost exceeds marginal social benefit).

Markets for Illegal Goods

Illegal Goods and Market Outcomes

Government may prohibit trade in certain goods (e.g., illegal drugs), but markets for these goods still exist.

• Penalties on sellers decrease supply, raise price, and lower quantity sold.

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

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

• Opportunity cost for buyers includes market price plus cost of breaking the law.

• Legalizing and taxing illegal goods can achieve similar outcomes to prohibition if tax is high enough.

Key Terms and Formulas

• Price Ceiling: Maximum legal price.

• Price Floor: Minimum legal price.

• Deadweight Loss: Loss of total surplus due to market inefficiency.

• Tax Incidence: Division of tax burden between buyers and sellers.

• Elasticity: Responsiveness of quantity demanded or supplied to price changes.

Formulas

• Deadweight Loss (DWL): $DWL = \frac{1}{2} \times (Q^* - Q_t) \times (P_b - P_s)$

• Tax Revenue: $\text{Tax Revenue} = \text{Tax per unit} \times \text{Quantity sold after tax}$

• Consumer Surplus: $CS = \int_{0}^{Q} (D(Q) - P) dQ$

• Producer Surplus: $PS = \int_{0}^{Q} (P - S(Q)) dQ$

Example Table: Effects of Price Controls

Policy	Market Outcome	Efficiency	Fairness
Rent Ceiling	Shortage, illegal trading, increased search	Inefficient (deadweight loss)	Unfair (allocation by luck, discrimination)
Minimum Wage	Unemployment, surplus of labour	Inefficient (deadweight loss)	Debated (may not benefit poor)
Tax	Reduced quantity, price wedge	Inefficient (deadweight loss)	Depends on incidence and principles
Quota	Reduced output, higher price	Inefficient (underproduction)	May benefit producers
Subsidy	Increased output, lower price	Inefficient (overproduction)	May benefit producers