Question

a. Use the model of demand and supply to explain the impact of a rent ceiling in the rental housing market in Perth, Western Australia. In your diagram, explain what would happen in the rental housing market if the price of non-rental apartments decreases. [6 marks]

b. Show the impact on the tobacco (cigarettes) market if the Russian government imposed a large tax on tobacco. Discuss the incidence of the tax. [5 marks]

c. What would happen in the tobacco market if the Russian government increased advertising explaining the negative health impacts from smoking? Why?

Answer 1

1. An economy can function efficiently with the intervention of the market forces of demand and sup[ply. One important area where the need of the hour is not merely the operation of the natural forces of demand and supply but active government control is needed is in case of ‘essential’ commodities. Apart from food, health –housing is also an essential commodity that has to be made available to all in the community. Hence the government will generally impose a ceiling or will bring in a law regarding rent controls, this is an aim to prevent landlords from charging exorbitant rents and aims to control exploitation in the name of higher rents.

In the diagram given above , the amount of ‘rent’ is taken on the Y axis, while the quantity of houses available for rent have been taken on X axis, the quantity of houses available depends upon the rents in a particular area.

The market forces of demand for rental accommodation and supply of rental homes intersect and it can be assumed that the rents in Perth, Western Australia, has been fixed at OP amount of rent while OQ is the amount of houses available , at the OP rent.

Since government regarded this rent as being too high it has decided to impose a rent ceiling to the extent of Pc, which is much lower than the market rate of OP.

At the rent ceiling of Pc, the demand for rental houses is Qd since the rental home seekers are happy about the price ceiling, yet the landlords express their displeasure by making available only Qs amount of rental homes.

Though the objective of the government was to increase the accessibility of rental homes to all yet ,the welfare purpose was defeated since the rent ceiling was not supported by the landlords.

If the price of non rental apartments decreases , assuming from OP to OPc then, there would be a rise in the demand for non – rental houses, yet the decreased price will not be attractive for sellers to sell their homes, though the buyers would find it attractive , since they have a choice of price ceiling of rental homes and low prices of non -rental homes.

For the landlords however , the price ceiling as well as the lower prices are not an optimum option to effect the transactions.

b.

Tobacco is a demerit good , in the sen though economically speaking it will bring profits for the producers of tobacco, yet when it is seen in terms of social welfare , it is a commodity which will have more adverse effects on the society than the benefits of its production and consumption. More so , it is a commodity which is addictive in nature and hence the consumers of tobacco generally give relatively low response to price changes. The government taxes such commodities to help the society realize the negative impact of the consumption of such goods.

However, the tax revenue generated from such commodities will either remain stable or rise since such goods are addictive in nature and the consumers would rather pay a higher tax than reduce the consumption of such commodities.

The tax levied on tobacco by the Russian government is an indirect tax, where the impact of the tax –the initial burden of paying the tax is called impact, which is borne by the seller , while the incidence of the tax—the ultimate burden is borne by the final consumer who buys the commodity for consumption.

In the diagram above, the price of tobacco is taken on the Y axis , while the quantity of tobacco is taken on the x axis. DD is the demand curve for tobacco which is steeper in slope indicating that the consumers of tobacco are addicted to the product and hence do not respond much to price changes.

SS is the supply curve of tobacco.

The initial price is OP at which OQ amount of tobacco is bought and sold. This is the initial equilibrium. The Russian government levy a tax on tobacco and the newer price that regains after tax is PT, the demand remains constant but the supply curve shifts to ST, it is a left ward shift indicating that sellers of tobacco are willing to supply less at a higher price due to the imposition of tax. This is because they are wary that they may lose the demand of some buyers, who may not be too addicted to tobacco and hence may withdraw or reduce its consumption , after the tax has been levied.

The newer equilibrium regains at OPT price , at which OQT quantity is sold. AE is the amount of tax borne by the buyer while EB is the amount of tax borne by the seller.

The incidence of tax falls on the buyer.

The tax burden is more on the buyer than the seller because the buyers are not responding much to the higher price of OPT and are willing to reduce their demand to a lesser extent than the rise in price. This is because of the inelasticity or non-responsive of their quantity of tobacco demanded to price changes.

c.

Suppose the Russian government increased the advertising campaign in order to create a greater awareness about the ill effects of tobacco consumption , then it will lead to a marginal fall in the demand for tobacco, since the desire for consuming such products is addictive and the consumers are more guided by non-price factors like the satisfaction resulting from tobacco consumption or an obsessive need to consume tobacco , their response to such advertising campaigns could be only a marginal decrease in their tobacco consumption. In such cases the burden of tax falls on the buyer more than the seller as the buyer will be willing to pay a higher price rather than go without consuming tobacco.

Yet for some other consumers for whom tobacco consumption is not an obsessive need such advertising campaigns will lead to a drastic fall in their demand for tobacco. It has to also be noted that such campaigns will lead to a fall in the number of prospective tobacco consumers who were previously possessing a desire to consume tobacco without being aware of its effects. In such cases however the burden of tax falls on the seller more than the buyer since these buyers are more price responsiveness and would drastically reduce their quantity demanded of tobacco even for a slightly higher price.