A Price Ceiling
A price ceiling is a legal restriction that prohibits exchanges at prices greater than a designated price: the ceiling price. Price ceilings are usually imposed when the equilibrium price is considered too high to be fair. A typical price ceiling results in a lower price than market forces would produce. A shortage will result in a situation in which the quantity demanded by consumers exceeds the quantity supplied by producers at the existing price.
A typical example of a price ceiling is a "rent ceiling," implemented by over 200 U.S. cities. 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.
If a rent ceiling is set below the equilibrium price P0, for example, at P1, there is a reduction in the quantity that producers are willing to supply qs and an increase in the quantity that consumers demand qd relative to the original equilibrium quantity q.
Because the legal price cannot eliminate the shortage, other mechanisms operate. For example, a black market is an illegal market that operates alongside a legal market in which a price ceiling or other restriction has been imposed. 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.
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 decreases the quantity of rental housing, shrinks the total producer and consumer surplus by using resources such as search activity, and creates a deadweight loss. It also transfers part of the producer surplus from producers to consumers. The consumer surplus becomes the green area + the pink area.
A Price Floor
A price floor is a minimum price that can be legally charged. It usually fixes the price of a good or resource above the market equilibrium level. Price floors are usually imposed when the equilibrium price is considered too low to be fair. Agricultural price supports and minimum wage legislation are examples of price floors.
If a price floor is set above the equilibrium price, p0, for example, at p1, there is a reduction in quantity demanded from q0 to qd, whilst the quantity supplied increases from q0 to qs. The result is a surplus of qs-qd.
Refer to the graph below. A price floor set by the government would be binding and cause the greatest distortion in the market if it were established at what price?
Given the supply and demand curves in the graph, the equilibrium price is $2.25. A price floor will be binding only if it is above the equilibrium price. So a price floor of $1.50 would not distort the market. The higher the floor above equilibrium price, the greater the market distortion (surplus). A price floor at $3.00 would create a larger surplus than a price floor at $2.50.
It creates a deadweight loss.
Note that a surplus does not mean the good is no longer scarce: people just desire less of the good at the current price than sellers desire to bring to the market. A decline in price would eliminate the surplus but not the scarcity of the item.
When a tax is imposed, the government can make either the buyer or the seller legally responsible for payment of the tax. However, the person who writes the check to the government is not necessarily the one who bears the tax burden.
The following graph illustrates how a $1,000 tax placed on the sale of used cars would affect the market. Assumption: all used cars are identical.
The effects of a tax depend on the responsiveness of buyers and of sellers to a change in price. It tends to fall more heavily on whichever side of the market has the least attractive options elsewhere and thus is less sensitive to price changes. This is because an inelastic curve indicates there are few substitutes available.
Initially, gas costs 50 cents per liter and 1,000 liters are sold per day. The demand curve is relatively inelastic, indicating there are few alternatives to gas.
A 20c tax per liter on suppliers shifts the supply curve up by 20c, establishing a new equilibrium price (65c) and quantity (950 liters). Consumers pay 15c more - meaning they have paid 15c of the 20c tax. Suppliers receive 65c from consumers, pay 20c to the government and are left with 45c - 5c less than before. Suppliers have thus paid 5c towards the tax.
The tax burden is thus:
Consumers pay more because their demand curve was relatively more inelastic than the supply curve.
Consider the diagram below. Here demand is relatively elastic and supply relatively inelastic.
The demand for luxury boats is relatively elastic as rich people have many alternatives as to how to spend their money. A $25,000 tax on the sale of these boats thus causes a large reduction in the quantity demanded (10 thousand to 5 thousand).
As the selling price only rises from $100,000 to $105,000, buyers have only paid only $5,000 of the tax. Sellers have thus paid $20,000 and received only $80,000 per yacht sold.
In practice, taxes usually are levied on goods and services with an inelastic demand or an inelastic supply. Alcohol, tobacco, and gasoline have inelastic demand, so the buyers of these items pay most of the tax on them. Labor has a low elasticity of supply, so the seller - the worker - pays most of the income tax and most of the Social Security tax.
A. there is a reduction in supply.
If price is not allowed to rise to the equilibrium level, then the market will not clear. Excess demand for goods that are priced below the equilibrium price will result and a black market for these goods will develop. The black market price will reflect the higher equilibrium price.
A. a lower equilibrium price for eggs as the demand curve for eggs shifts left
A price floor above the equilibrium price will result in a higher quantity supplied and a lower quantity demanded. Price floors will not shift the supply or demand curves for the good in question. A higher price will result in a decrease in the quantity demanded, according to the law of demand.
A. immediately stop producing the good.
I. sellers will bear the full burden of the tax.
The tax will raise the supply curve by $3.00 but the price will increase by a smaller amount because the quantity demanded shrinks as the price rises. The statutory incidence of the tax is entirely on the sellers but the actual incidence is shared by buyers and sellers. The tax will be absorbed in part by buyers and in part by sellers.
A. a decrease in demand, lower prices, and a higher quantity
A tax shifts the supply vertically and supply decreases. The decrease in supply reduces the equilibrium quantity and raises the equilibrium price.
I. an example of a price floor and cause the quantity of housing demanded to exceed the quantity supplied.
A. there will be a shortage of 400 labor hours.
At $5.15 per hour, the quantity demanded is 500 and the quantity supplied is 900, resulting in a surplus of 400.
A. the after-tax market price minus the tax
The tax burden imposed on buyers is equal to the difference between the post-tax and pre-tax market prices.
A. higher prices and higher quantities traded
A. the smaller the quantity changes when a tax is imposed.
When demand is elastic, buyers will be able to shift a larger share of the tax to the sellers.
I. More housing will be constructed than would otherwise be.
A. demand is elastic.
A tax imposed on a good whose demand is elastic results in a large quantity change and a small price change.
I. If the government imposes a price floor, consumer surplus will increase.
A price floor is a legal minimum price. Increasing the price causes a surplus, decreases consumer surplus, and decreases total surplus. While some firms will gain, others will be unable to sell their products at the higher price and may be worse off.
A. upward and the price will increase by $5.
An excise tax on suppliers shifts the supply curve up by the amount of the tax. The equilibrium price will increase by $5 if demand is vertical or perfectly inelastic.
I. There will be a shortage of unskilled labor.
I. rise by the full amount of the tax.
Statement I: The buyer pays the tax.
Statement II: The buyer and seller share the burden of the tax.
Statement III: The seller pays the tax.
I. economic growth
A. In the long run, as demand increases, apartment shortages are likely to become more severe and the quality of rent-controlled apartments is likely to decline.
Low apartment prices give landlords little incentive to maintain quality, and likewise, apartments will become even scarcer as demand increases. Any time there is a shortage, consumers will "pay" a higher price in terms of time searching. While some of the poor are likely to benefit from rent control, anyone who gets such an apartment gains, and some of those people may not be poor. Additionally, if there is "key money" or other bribery, other parties, such as apartment owners, may gain.
A. free market
A black market is an illegal market that operates alongside a legal market in which a price ceiling or other restriction has been imposed
I. unemployment for low-skilled employees will increase.
A. I and II
A legislated minimum wage will put the wage rate above the market clearing level and will result in a surplus of low-skilled labor. This surplus labor is unemployed. To cut costs, employers will cut non-wage benefits to employees (such as job training).
A. There will be a shortage.
An effective price floor will set the price above the equilibrium price. At such a price, quantity supplied will exceed quantity demand. This is the definition of a surplus.
A. There will be a shortage.
To be effective, a price floor must be above the market price. As, in this case, the legal minimum price is below the equilibrium price, it will have no effect on the market.
A. the greater the share of the tax paid by buyers
When demand is inelastic, sellers will be able to shift a larger share of the tax on to buyers.
A. sellers will bear the larger share of the tax burden.
When demand is relatively elastic compared to supply, sellers will bear the larger share of the tax burden.
A. unitary elasticity of demand
A. a smaller quantity traded and a larger deadweight loss
A. price ceiling
A. Sellers pay the entire tax.
Under perfectly elastic demand, sellers pay the entire tax.
A. New housing construction expands.
Rent ceilings reduce construction and create a housing shortage. They lower rents for some but raise them for others. Long-time renters are winners but mobile newcomers are losers.