- CFA Exams
- 2017 Level I > Study Session 4. Economics > Priliminary Reading 1. Demand and Supply Analysis: Introduction
- 6. Market Interference: The Negative Impact on Total Surplus
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Subject 6. Market Interference: The Negative Impact on Total Surplus
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.
- Before the imposition of the tax, used cars sold for a price of $7,000 (point A).
- The tax has statutorily been placed on the seller, shifting the supply curve upward by exactly the amount of tax ($1,000).
- Now the price will rise to $7,400 (point B). Therefore, despite the tax being statutorily imposed on sellers, the higher price shifts some of the tax burden to buyers.
- A buyer will now pay $400 more for a used car.
- A seller now receives $7,400 from the sale of a used car, but after sending the tax of $1,000 to the government, the seller retains only $6,400. This is exactly $600 less than the seller would have received had the tax not been imposed.
- In this case, each $1,000 of tax revenue transferred to the government imposes a burden of $400 on the buyer and a $600 burden on the seller.
- As the example shows, the imposition of the $1,000 tax on used cars causes the number of units exchanged to fall from 750 to 500. As trade results in mutual gains for both buyers and sellers, the loss of mutual benefits that would have been derived had the tax not eliminated 250 units of exchange also imposes a cost on buyers and sellers. The loss is referred to as the deadweight loss of taxation. In the graph, the triangle ABC measures the size of the deadweight loss. It generates neither revenue for the government nor gains for any other party.
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.
- When demand is relatively inelastic and supply elastic, the primary burden of a tax will fall on buyers.
- Consumers: 15c
- Suppliers: 5c
- When demand is relatively elastic compared to supply, sellers will bear the larger share of the tax burden.
- The deadweight loss is reduced if the elasticity of either demand or supply is reduced (i.e., its curve becomes steeper). Except in the extreme cases of perfectly inelastic demand or supply when the quantity remains the same, imposing a tax creates inefficiency.
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.
Practice Question 1Black markets are most likely to arise when ______
A. there is a reduction in supply.
B. demand increases.
C. a price ceiling is imposed. Correct Answer: C
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.
Practice Question 2Suppose a price floor is imposed on eggs above their equilibrium price. The likely result will be ______.
A. a lower equilibrium price for eggs as the demand curve for eggs shifts left
B. a higher equilibrium price for eggs as the supply curve for eggs shifts left
C. a decrease in the quantity of eggs demandedCorrect Answer: C
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.
Practice Question 3A price floor causes excess demand, resulting in the need to ration by some means other than price. True or False?Correct Answer: False
Practice Question 4When a price ceiling is imposed below the market equilibrium, suppliers will ______
A. immediately stop producing the good.
B. direct resources away from production of the commodity and into other less profitable areas.
C. direct resources away from production of the commodity and into other more profitable areas.Correct Answer: C
Practice Question 5If a new excise tax of $3.00 per gallon of gasoline sold is imposed on sellers of gasoline, ______
I. sellers will bear the full burden of the tax.
II. gasoline will rise in price by $3.00.
III. the statuary incidence and actual incidence of the tax will be the same.Correct Answer: None of these answers are correct.
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.
Practice Question 6The market effects of a per-unit tax on sellers include ______.
A. a decrease in demand, lower prices, and a higher quantity
B. an increase in supply, higher prices, and a lower quantity
C. a decrease in supply, higher prices, and a lower quantityCorrect Answer: C
A tax shifts the supply vertically and supply decreases. The decrease in supply reduces the equilibrium quantity and raises the equilibrium price.
Practice Question 7Rent controls are ______
I. an example of a price floor and cause the quantity of housing demanded to exceed the quantity supplied.
II. in the best interest of all renters.
III. used in most U.S. cities.
IV. an example of a price ceiling and cause the quantity of housing demanded to exceed the quantity supplied.Correct Answer: IV
Practice Question 8Refer to the graph below. If government establishes a price floor of $5.15 per hour, ______
A. there will be a shortage of 400 labor hours.
B. there will be a surplus of 400 labor hours.
C. there will be a shortage of 300 labor hours. Correct Answer: B
At $5.15 per hour, the quantity demanded is 500 and the quantity supplied is 900, resulting in a surplus of 400.
Practice Question 9The tax burden that falls on buyers is equal to ______.
A. the after-tax market price minus the tax
B. the after-tax market price minus the pre-tax market price
C. the pre-tax price plus the taxCorrect Answer: B
The tax burden imposed on buyers is equal to the difference between the post-tax and pre-tax market prices.
Practice Question 10Making the supply of a good or service illegal will result in ______.
A. higher prices and higher quantities traded
B. lower prices and higher quantities traded
C. higher prices and lower quantities tradedCorrect Answer: C
Practice Question 11The more elastic the demand for a good, ______
A. the smaller the quantity changes when a tax is imposed.
B. the greater the share of the tax paid by buyers.
C. the greater the share of the tax paid by sellers.Correct Answer: C
When demand is elastic, buyers will be able to shift a larger share of the tax to the sellers.
Practice Question 12Rent controls can be expected to have the following result(s):
I. More housing will be constructed than would otherwise be.
II. Owners of existing housing units will be anxious to fix up their units.
III. Renters with long-term leases will benefit at the expense of newcomers.
IV. Everyone, both renters and owners, will be happy.Correct Answer: III
Practice Question 13Taxes have a large impact on quantity and a small impact on price when ______
A. demand is elastic.
B. supply is inelastic.
C. supply is inelastic and demand is inelastic.Correct Answer: A
A tax imposed on a good whose demand is elastic results in a large quantity change and a small price change.
Practice Question 14Which of the following is a true statement about the effect of a government-imposed price floor?
I. If the government imposes a price floor, consumer surplus will increase.
II. If the government imposes a price floor, all firms will gain.
III. If the government imposes a price floor, there will be a shortage.
IV. If the government imposes a price floor, total surplus will decrease.Correct Answer: IV
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.
Practice Question 15If the government imposes an excise tax on a good equal to $5 per unit and the demand curve for this good is vertical, the supply of this good will shift ______
A. upward and the price will increase by $5.
B. upward and the price will increase by less than $5.
C. downward and the price will decrease by less than $5.Correct Answer: A
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.
Practice Question 16Assume that unskilled workers, on average, are worth $5 per hour to employers, but that Congress enacts a minimum wage law that requires employers to pay $6 per hour. This law will cause which of the following results?
I. There will be a shortage of unskilled labor.
II. There will be a surplus of unskilled labor.
III. All unskilled persons will benefit from the $6 minimum wage law.
IV. Business costs will decrease and employers will lower the prices of goods and services sold in product markets.Correct Answer: II
Practice Question 17When an item is taxed, its price might ______
I. rise by the full amount of the tax.
II. rise by a lesser amount.
III. not rise at all.Correct Answer: I, II and III
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.
Practice Question 18Minimum wage legislation leads to ______.
I. economic growth
III. capital accumulation
IV. unemploymentCorrect Answer: IV
Practice Question 19Which of the following is NOT a true statement about rent control?
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.
B. Consumers will have to spend more time searching for apartments if there are rent controls.
C. The only people who benefit from rent controls are the poor.Correct Answer: C
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.
Practice Question 20When a price ceiling causes an excess demand which leads to an illegal market in which the price exceeds the legally imposed price ceiling, the illegal market is called a ______.
A. free market
B. regulated market
C. black marketCorrect Answer: C
A black market is an illegal market that operates alongside a legal market in which a price ceiling or other restriction has been imposed
Practice Question 21If a legislature decides to reduce poverty by passing a law requiring that employers pay higher wages, economic theory and historical experience suggest that ______
I. unemployment for low-skilled employees will increase.
II. a market surplus of low-skilled labor will develop.
III. employers will offer less job training to low-skilled employees.
A. I and II
B. I and III
C. I, II and IIICorrect Answer: C
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).
Practice Question 22If an effective minimum price is imposed by the government, what would be expected to occur?
A. There will be a shortage.
B. There will be a surplus.
C. Nothing; the price is not an equilibrium price.Correct Answer: B
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.
Practice Question 23The market price of wheat is $2. The government imposes a legal minimum price (price floor) of $1.50. What will be the effect on the market?
A. There will be a shortage.
B. There will be a surplus.
C. There will be no effect.Correct Answer: C
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.
Practice Question 24When demand is relatively inelastic, ______.
A. the greater the share of the tax paid by buyers
B. the greater the share of the tax paid by sellers
C. The elasticity of demand does not affect the market effects of a tax.Correct Answer: A
When demand is inelastic, sellers will be able to shift a larger share of the tax on to buyers.
Practice Question 25When demand is relatively elastic compared to supply, ______
A. sellers will bear the larger share of the tax burden.
B. buyers will bear the larger share of the tax burden.
C. the tax payable by sellers tends to be large.Correct Answer: A
When demand is relatively elastic compared to supply, sellers will bear the larger share of the tax burden.
Practice Question 26If the government wants to increase tax revenues, it should tax goods and services that have a(n) ______.
A. unitary elasticity of demand
B. high elasticity of demand
C. low elasticity of demandCorrect Answer: C
Practice Question 27If both demand and supply are perfectly inelastic, a tax results in ______.
A. a smaller quantity traded and a larger deadweight loss
B. no change in quantity and no deadweight loss
C. a smaller quantity traded and a smaller deadweight lossCorrect Answer: B
Practice Question 28An alternative to making a good or service illegal that would have the same effect on price and quantity traded is a ______.
A. price ceiling
C. price floorCorrect Answer: B
Practice Question 29Which of the following statements is most accurate in regard to the tax division between buyers and sellers of products with perfectly elastic demand?
A. Sellers pay the entire tax.
B. Buyers bear the entire tax burden.
C. Buyers and sellers share the tax burden.Correct Answer: A
Under perfectly elastic demand, sellers pay the entire tax.
Practice Question 30When rent controls limit rents to prices below equilibrium prices, which of the following is most likely to occur?
A. New housing construction expands.
B. Long-time tenants extract significant benefit from landlords.
C. Newcomers are given preferential entry into rent-controlled apartments.Correct Answer: B
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.
Study notes from a previous year's CFA exam: