Government Control of Prices in Mixed Systems

Supply, Demand, and Government Policies

   In a free, unregulated market system, market forces establish equilibrium prices and exchange quantities.

Prices in mixed systems are not necessarily a response to market demand and supply Sometimes the government sets a minimum or a maximum price for certain goods.

CONTROLS ON PRICES

  Are usually enacted when policymakers believe the market price is unfair to buyers or sellers. Examples: price ceilings and floors.

Are Price controls Effective?

  Can government control of prices improve the market outcome?

In principle, there are two lessons to be learn:  The market reacts to the government’s policies which in many cases weakens the effect of the policy  Unexpected and negative consequences result from government intervention

CONTROLS ON PRICES



Price Ceiling

 A legal maximum on the price at which a good can be sold.  Set by the government to  limit inflation or to  Keep prices of selective goods affordable for low income individuals  Used in many cities to keep housing costs down  In 1970 more than 200 US cities enacted some form of rent control

CONTROLS ON PRICES



Price Floor

 A legal minimum on the price at which a good can be sold.

 Typically used to benefit the sellers of a certain good  The 1938 Fair Labor Standards Act established the first federal minimum wage laws  Minimum wage laws were widely supported as a means to maintaining the minimum standards of living

Rent Control

 Rent controls are ceilings placed on the rents that landlords may charge their tenants.

 The goal of rent control policy is to help the poor by making housing more affordable.

 One economist called rent control “the best way to destroy a city, other than bombing.”

Demand for Housing

    The demand curve shows the total number of housing units demanded at each price Demand is downward sloping As the rental price increases, households substitute away from housing by  Sharing housing units with others  Consuming smaller housing units Housing demand is inelastic in the short run 0

Rent

Demand

Quantity

Supply for Housing

    The supply curve shows the total number of housing units supplied at each price Supply is upward sloping As the rental price increases, more housing units will be available through  Construction of new units (long run)  Conversion from other uses (short run) Housing supply is inelastic in the short run 0

Rent

Supply

Quantity

Equilibrium

  An increase in demand results in a higher rental price and an increase in quantity supplied of rental apartments In the long run, new housing units are constructed as investment in housing becomes more profitable and the supply shifts right

Rent

0 S1 S2 D2 D1

Quantity

Rent Control

 Rent control was enacted before WWII, as policy makers were worried about inflation.

 After WWII, several American cities kept rent control regulations in place to keep housing affordable for low income groups  What are the actual effects?

Effect of Rent Control

 A shortage results, which grows with increasing demand  People are forced to delay the decision to move out of rent controlled units or to add to their living space.

$500 400

Rent

0 Supply 9 Quantity supplied Shortage Rent Control Demand 11 Quantity demanded

Quantity

Effect of Rent Control

 Rent is not low for everyone  Since a rent higher than $400 is illegal, the market cannot work to allocate the housing units among people.

$500  Illegal payments to landlords  Rent is higher in non rent controlled areas 400

Rent

0 Supply 9 Quantity supplied Shortage Rent Control Demand 11 Quantity demanded

Quantity

Long Run Effects

 No incentives to construct new housing units as it becomes less profitable  Housing supply shrinks in the long run as some home builders exit the market  Fewer rent controlled housing units which contributes to homelessness

Long Run Effects

 Housing quality deteriorates as landlords have less incentives to maintain them  Resource misallocation occurs as goods of value are underprovided since the price is not allowed to reflect housing value.

Minimum Wage

  Setting a minimum hourly wage is seen as a way to preserve a certain level of income for those at the end of the income scale Questions:    Do all workers benefit from the minimum wage?

What are the consequences on the labor market?

How does the minimum wage affect poverty?

Labor Demand

  Demand for labor is downward sloping Demand for labor is a derived demand Labor demand

Quantity of Labor

Deriving Labor Demand

 When an additional worker is hired, production increases and thus the total revenue of the firm increases  This increase in revenue is called the

marginal revenue product

hiring that worker , which is the marginal benefit of

Labor

0 1 2 3 4 5 6 7

Total Product

0 5 25 50 70 80 85 86

Marginal Product MRP

Deriving Labor Demand

    As additional workers are hired output increases at a decreasing rate The additional output, i.e.,

Marginal Product,

declines This is referred to as

of Diminishing Marginal Product the law

Assume price= $0.5

Labor

4 5 6 0 1 2 3

Total Product

0 30 50 65 79 84 86

Marginal Product 14 5 2 30 20 15 MRP 15 10 7.5

7 2.5

1

Deriving Labor Demand

    Hiring an extra worker raises the cost for the firm The cost of hiring an extra worker is the wage,

W

The extra worker will be hired if the marginal benefit exceeds (or equals) the marginal cost of hiring him.

The extra worker will be hired if: the

MRP >=W

Labor Demand

   If W=2.5, How many workers will be hired?

If W=5, How many workers will be hired?

MRP

The labor demand curve is the downward sloping part of the MRP curve 5 2.5

1 Labor Demand 5 6

Quantity of Labor

Labor Supply What will happen to the number of hours worked as the wage rate increases?

 Time allocate between work and leisure  Substitution effect: work more consume less leisure  Income effect: higher income leads to consuming more leisure and working less General Conclusion: Labor supply is upward sloping

How the Minimum Wage Affects the Labor Market

Wage

Labor Supply Labor surplus (unemployment) Minimum wage Equilibrium wage 0 Quantity demanded Quantity supplied Labor demand

Quantity of Labor

How the Minimum Wage Affects the Labor Market

  The minimum wage results in an increase in the quantity supplied of workers and a decline in the quantity demanded.

Unemployment results as workers who are willing to work at the min wage are more than the jobs offered

Who gets to work at the minimum wage?

    The answer will determine the distributional impact of the policy Several researches suggests that employers when faced with a larger labor pool under the minimum wage law, can discriminate between workers.

Teenagers tend to be discriminated against due to their limited training and education relative to others in the pool Similarly for women and minorities.

TAXES

 Governments levy taxes to :  raise revenue for public projects  Change market price to reduce trade in a particular good

How Taxes Affect Market Outcomes

 Tax incidence  Tax incidence is the manner in which the burden of a tax is shared among participants in a market.

 Tax incidence is the study of who bears the burden of a tax.  Taxes result in a change in market equilibrium.

How Taxes Affect Market Outcomes

 When a tax is imposed there are two prices of interest:   The price that the buyers pay, 𝑃 𝐵 . The price that sellers receive, 𝑃 𝑆 .

 The difference between the two is the tax,

t

.

 Let’s first consider a tax on sellers.

A Tax on Sellers

Price

Price buyers pay 3.00

Price Sellers get 0

S

1 100 Demand, D 1

Quantity of Ice-Cream Cones

A Tax on Sellers

Price

$2.50

2.00

Tax ($0.50)

S

2

S

1 A tax on sellers shifts the supply curve upward by the amount of the tax ($0.50).

0 50 Demand, D 1

Quantity of Ice-Cream Cones

A Tax on Sellers

Price of Ice-Cream Cone

𝑃 𝐵 Price Before tax $3.30

3.00

2.80

Tax ($0.50) 𝑃 S 0

S

2

S

1 90 100 Demand, D 1

Quantity of Ice-Cream Cones

A tax on the buyer vs. a tax on the seller?

 A $t tax imposed on the buyer has the same effect as a $t tax imposed on the sellers  The price received by the seller is the same.

   The price paid by the buyer is the same.

The tax creates a wedge between the supply and demand curves.

The burden of the tax is shared between buyers and sellers.

Effects of a tax

Price

Price buyers pay ($3.3) Price without tax Price sellers Receive ($2.8) Tax wedge ($0.5) 0 Qt

S

 Losers: both buyers and sellers, regardless of who the tax is imposed on  Winners: government revenue  The tax results in a reduction in quantity

D Quantity

How the Minimum Wage Affects the Labor Market

Wage

Labor demand Labor Supply 5 7 0 50 70

Quantity of Labor