Economics: Resource Markets, Price Controls, and Consumer Choice

Posted on Mar 28, 2025 in Economy

Chapter 4: Resource and Product Markets

The Link Between Resource and Product Markets

• The markets for resources and products are closely linked.
• Changes in one will affect the other.

Economics of Price Controls

Price Ceilings

• A price ceiling is a legally established maximum price that sellers may charge.
• The direct effect of a price ceiling below the equilibrium price is a shortage: quantity demanded exceeds quantity supplied.

Secondary Effects of Price Ceilings

• Reduction in the quality of the good.
• Inefficient use.
• Lower future supply.
• Non-price rationing will be of more importance.

Effects of Rent Control

• Shortages and black markets will develop.
• The future supply of housing will decline.
• The quality of housing will deteriorate.
• Non-price methods of rationing will increase in importance.
• Inefficient use of housing will result.
• Long-term renters will benefit at the expense of newcomers.

Price Floor

• A price floor is a legally established minimum price that buyers must pay.
• The direct effect of a price floor above the equilibrium price is a surplus: quantity supplied exceeds quantity demanded.

Minimum Wage Effects

• Direct effect.
• Indirect effects.
• A higher minimum wage does little to help the poor.

Black Markets and the Legal Structure

Black Markets

• Black market: markets that operate outside the legal system.
• Either sell illegal items or items at illegal prices or terms.
• Black markets have a higher incidence of defective products, higher profit rates, and greater violence.

Legal System

• A legal system that provides secure property rights and unbiased enforcement of contracts enhances the operation of markets.

The Impact of a Tax

Tax Incidence

• The legal assignment of who pays a tax is called the statutory incidence.

Tax Rates, Tax Revenues, and the Laffer Curve

Average Tax Rate

• Average tax rate equals tax liability divided by taxable income.
• A progressive tax is one in which the average tax rate rises with income.
• A proportional tax is one in which the average tax rate stays the same across income levels.
• A regressive tax is one in which the average tax rate falls with income.

Marginal Tax Rate

• Marginal tax rate equals change in tax liability divided by change in taxable income.

Tax Rate and Tax Base

• Tax rate is the percentage rate at which an economic activity is taxed.
• Tax base is the level of the activity that is taxed.

Laffer Curve

• The Laffer curve illustrates the relationship between tax rates and tax revenues.

Laffer Curve and Tax Changes in the 1980s

• During the 1980s, the top marginal income tax rate fell from 70% to 33%.
• Need to distinguish between changes in tax rates and changes in tax revenues.

The Impact of a Subsidy

Benefit of a Subsidy

• The division of a benefit from a subsidy is determined by the relative elasticities of demand and supply rather than to whom the subsidy is actually paid.

Chapter 5: Economic Efficiency and the Role of Government

A Closer Look at Economic Efficiency

• Economists often use the concept of efficiency to judge actions because the efficient use of resources implies the maximum value of output from the resource base.

Two conditions are necessary for ideal economic efficiency:

• All activities that provide individuals with more benefits than costs must be undertaken.
• No activities that provide benefits less than costs should be undertaken.

If It’s Worth Doing, It’s Worth Doing Imperfectly

• Although perfection is a noble goal, it is rarely worth achieving because additional time and resources devoted to an activity generally yield smaller and smaller benefits and cost more and more.
• Inefficiency can result when either too little or too much effort is put into an activity.

Thinking About the Economic Role of Government

Protective Function of Government

• The most fundamental function of government is the protection of individuals and their property against acts of aggression.
• Involves the maintenance of a legal structure (rules) within which people interact peacefully and have a process for the settlement of disputes.

Productive Function of Government

• Involves the provision of a limited set of goods that are difficult to supply through the market.

Potential Shortcomings of The Market

• There are four major reasons why the invisible hand may fail to allocate resources efficiently: (1) Lack of competition, (2) Externalities, (3) Public goods, and (4) Poor information.

Lack of Competition

• Sellers may gain by restricting output and raising price. Too few units will be produced.

Externalities

• The failure to fully register costs and benefits.

Public Goods

Problems Arising from Poor Information

Market Failure and Government Failure

Market Failure

• Market failure is the term used to describe the failure of markets to achieve the ideal conditions of economic efficiency.
• When markets allocate goods inefficiently, the problem can generally be traced back to the absence of competition, externalities, public goods, or poor information.

Government Failure

• Government failure is the term used to describe the situation when there is reason to anticipate that political decision-making will fail to achieve the ideal conditions of economic efficiency.
• Government action directed by political decision-making is merely an alternative form of economic organization. It is not a corrective device that can be counted on to provide a remedy for the shortcomings of markets.
• Merely because market failure is present, it does not follow that political action will necessarily lead to a more efficient allocation of resources.

Chapter 6: Government and the Political Process

The Size and Growth of the U.S. Government

• Total government spending accounted for only 9.4% of GDP in 1930, and only one third of this spending was at the federal level.
• Government spending, particularly at the federal level, soared from 1930 to 1980. Total government spending rose from 9.4% of GDP in 1930 to 32.8% in 1980 (more than 3 times its 1930 level).
• After remaining fairly constant between 1980 and 2000, the size of the US government has increased dramatically since (increasing to almost 40% of the U.S. economy in 2010).
• Personal income and payroll taxes provide about one-half of government revenue.
• The largest categories of government spending are education, health care, Social Security and other transfer payments.

The Differences and Similarities Between Governments and Markets

• Competitive behavior is present in both the market and public sectors.
• Public-sector organization can break the individual consumption-payment link.
• Scarcity imposes the aggregate consumption-payment link in both sectors.
• Private-sector action is based on voluntary choice; public sector (when democratic) is based on majority rule.
• When collective decisions are made legislatively, voters must choose among candidates who represent a bundle of positions on issues.
• Income and power are distributed differently in the two sectors.

Political Decision-Making: An Overview

• Public choice analysis applies the tools of economics to the political process. The goal is to provide insight concerning how the process works.

Self-interested behavior is present in both market and political sectors.

Political process can be viewed as a complex exchange process involving:

1. Voter-taxpayers
2. Politicians
3. Bureaucrats

Incentives Confronted by the Voter

• Voters will tend to support those candidates whom they believe will provide them the most government services and transfer benefits, net of personal costs.
• Rational Ignorance Effect: Recognizing their vote is unlikely to be decisive, most voters have little incentive to obtain information on issues and alternative candidates.
• Because of the rational ignorance effect, voters will be uninformed on many issues; such issues will not enter into their decision-making process.

Incentives Confronted by the Politician

• Political officials: interested in winning elections. Just as profits are the lifeblood of the market entrepreneur, votes are the lifeblood of the politician.
• Rationally uninformed voters often must be convinced to “want” a candidate.
• Legislative bodies are something like a Board of Directors.

Incentives Confronted by the Government Bureaucrat

• Bureaucrats (persons that handle day-to-day operations of government) seek promotions, job security, power, etc.
• The interests of bureaucrats are often complementary with those of the interest groups they serve.
• Bureaucrats can usually expand their own interests, as well as that of their constituents, by working for larger budgets and program expansion.

When the Political Process Works Well

• Other things constant, legislators will have a strong incentive to support the political actions that provide voters with large total benefits relative to costs.
• If a government project is really productive, it will always be possible to allocate the project’s cost so that all voters will gain.
• When voters pay in proportion to benefits received, all voters will gain if the government action is productive (and all will lose if it is unproductive.) Under these circumstances, there is a harmony between good politics and economic efficiency.

When the Political Process Works Poorly

Special Interest Effect

• Special Interest Issue: One that generates substantial personal benefits for a small number of constituents while imposing a small individual cost on a large number of other voters.
• Members of an interest group will feel strongly about an issue that provides them with substantial personal benefits. Such issues will dominate their political choices.
• In contrast, the voters bearing the cost of special-interest legislation will often be uninformed on such an issue because it exerts only a small impact on their personal welfare and because they are unable to avoid the cost by becoming better informed.
• Politicians have a strong incentive to favor special interests even if action is inefficient.
• Logrolling and pork-barrel legislation strengthen the special interest effect.

Shortsightedness Effect

• Issues that yield clearly defined current benefits at the expense of future costs that are difficult-to-identify.
• The political process is biased toward the adoption of such proposals even when they are efficient.

Rent Seeking

• Actions by individuals and interest groups designed to restructure public policy in a manner that will either directly or indirectly redistribute more income to themselves.
• Widespread use of the taxing, spending, and regulating powers of government that favors some at the expense of others will encourage rent seeking.
• Rent seeking moves resources away from productive activities. The output of economies with substantial amounts of rent seeking will fall below their potential.

Inefficiency of Government Operations

• In the public sector, the absence of the profit motive reduces the incentive of producers to keep costs low.
• Neither is there a bankruptcy process capable of weeding out inefficient producers.
• Public-sector managers are seldom in a position to gain personally from measures that reduce costs.
• Because public officials and bureau managers spend other people’s money, they are likely to be less conscious of cost than they would be with their own resources.

Political Favoritism, Crony Capitalism, and Government Failure

Crony capitalism is the situation where…

• Political decision-makers direct subsidies, grants, tax breaks, and regulatory favors toward businesses willing to provide them with campaign funds and other forms of political support.
• It is a natural outgrowth of increases in government spending, constant changes in taxes, and expansion in regulation.

Crony Capitalism is often driven by the bootlegger–Baptist strategy: greedy action packaged as moral behavior

• Opportunistic rent-seekers often frame their programs in a manner designed to attract support from naïve idealists.
• They argue their programs will enhance child safety, promote energy independence, save family farms, or some other widely supported goal.
• But when one looks below the surface, one discovers that these programs are about government favoritism providing handsome profits to the well-organized special interest groups.

Bootlegger—Baptist examples include:

• Mattel incorporating costly testing procedures into the Consumer Product Safety Improvement Act of 2008.

1. The action increased the costs of rivals and drove used toy sellers like Goodwill out of the market.

• General Electric partners with environmentalists to advocate subsidies and tax breaks for alternative energy sources.

1. This government favoritism increased demand for GE turbine engines, solar panels, and wind farms.
2. Result: GE earned $15 billion in 2010 and paid zero corporate income taxes.

Market Entrepreneurs versus Crony Capitalists

• Market entrepreneurs get ahead by providing consumers with products that are more highly valued than the resources required for their production.
• Crony capitalists get ahead by providing political players with campaign contributions and other political resources in exchange for government contracts, subsidies, tax benefits, and other forms of political favoritism

1. Projects of crony capitalists will often be counterproductive.
2. Crony capitalism reflects government failure and undermines the legitimacy of the democratic political process.

The Economic Way of Thinking About Government

• Both bad news and good news flow from public-choice analysis.

1. The bad news: For certain classes of economic activity, unconstrained democratic government will predictably be a source of economic waste and inefficiency.
2. The good news: Properly structured constitutional rules can improve the expected result from government.

• The incentive to economize is reduced when payment is made by a third party (health care) and when production is handled by the government (national defense, post office).

Chapter 7: The Fundamentals of Consumer Choice

Fundamentals of Consumer Choice

• Limited income necessitates choice.
• Consumers make choices purposefully.
• One good can be substituted for another.
• Consumers must make decisions without perfect information, but knowledge and past experience will help.
• The law of diminishing marginal utility applies.

1. As the rate of consumption increases, the marginal utility derived from consuming additional units of a good will decline.

Marginal Utility, Consumer Choice, and the Demand Curve of an Individual

The Demand Curve

• The height of an individual’s demand curve is equal to the maximum price the consumer would be willing to pay for that unit—its marginal benefit.
• A consumer’s willingness to pay for a unit of a good is directly related to the utility derived from consumption of the unit.
• The law of diminishing marginal utility implies that a consumer’s marginal benefit, and thus the height of their demand curve, falls with the rate of consumption.

Consumer Equilibrium with Many Goods

• Consumer will maximize his/her satisfaction by ensuring that the last dollar spent on each commodity yields an equal degree of marginal utility.

Price Changes and Consumer Choice

• The demand curve shows the amount of a product that consumers would be willing to purchase at alternative prices during a specific time period.
• The law of demand states that the amount of a product purchased is inversely related to its price.

Reasons for downward slope of demand curve:

1. Substitution effect: as the price of a product declines, consumers buy more of it and less of other now more expensive products.
2. Income effect: as product price falls, consumer’s real income rises and this induces them to buy more of the product and other goods.

Time Cost and Consumer Choice

• The monetary price of a good is not always a complete measure of its cost to the consumer.
• Consumption of most goods requires time as well as money; and time, like money, is scarce to the consumer.

1. So a lower time cost, like a lower money price, will make a product more attractive.
2. Time costs, unlike money prices, differ among individuals.

Market Demand Reflects the Demand of Individual Consumers

Individual and Market Demand Curves

• The market demand curve for a product is the horizontal sum of people’s individual demand curves.

Elasticity of Demand

Elasticity of Demand

• Price elasticity reveals the responsiveness of the amount purchased to a change in price.

Determinants of Price Elasticity of Demand

1. Availability of substitutes

• When good substitutes for a product are available, a price rise induces many consumers to switch to other products and demand is elastic.

1. Share of total budget expended on product

• As the share of the total budget expended on the product rises, demand is more elastic.

Time and Demand Elasticity

• If the price of a product increases, consumers will reduce their consumption by a larger amount in the long run than in the short run.

1. Thus, the demand for most products will be more elastic in the long run than in the short run.

• This relationship is often referred to as the second law of demand.

How Demand Elasticity and Price Changes Affect Total Expenditures (or Revenues) on a Product

• When the demand for a product is elastic, a price change will cause total spending on it to change in the opposite direction.
• When demand for a product is inelastic, a change in price will cause total spending on it to change in the same direction.

Income Elasticity

Income Elasticity

• Income elasticity indicates the responsiveness of the demand for a product to a change in income.
• A normal good is any good with a positive income elasticity of demand.

1. As income expands, the demand for inferior goods will rise.

• Goods with a negative income elasticity are inferior goods.

1. As income expands, the demand for inferior goods will decline.

The Price Elasticity of Supply

Price Elasticity of Supply

• The price elasticity of supply is the percent change in quantity supplied divided by the percent change in the price causing the supply response.

1. It is analogous to the price elasticity of demand.
2. However, the price elasticity of supply will be positive because the quantity producers are willing to supply is directly related price.