1. Government Control of Prices in Mixed Systems

2. 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. 2 2

3. CONTROLS ON PRICES
Are usually enacted when policymakers believe the market price is unfair to buyers or sellers.
Examples: price ceilings and floors. 3 3

4. 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

5. 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 4 4

6. 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 4 4

7. 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.” 2

8. 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
Rent
Demand
Quantity

9. 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
Rent
Supply
Quantity

10. 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 S2 D2 S1 D1
Quantity

11. 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? 2

12. Effect of Rent Control
Rent
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.
Supply
Demand
$500
400
Rent
Control 9 11
Shortage
Quantity
Quantity
supplied
Quantity
demanded

13. 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.
Illegal payments to landlords
Rent is higher in non rent controlled areas
Supply
Demand
$500
400
Rent
Control 9 11
Shortage
Quantity
Quantity
supplied
Quantity
demanded

14. 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 2

15. 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. 2

16. 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?

17. Labor Demand Demand for labor is downward sloping
Demand for labor is a derived demand
Wage
Labor
demand
Quantity of
Labor

18. Deriving Labor Demand
Labor
Total
Product
Marginal Product
MRP 1 5 2 25 3 50 4 70 80 6 85 7 86
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, which is the marginal benefit of hiring that worker

19. Deriving Labor Demand
Labor
Total
Product
Marginal Product
MRP 1 5 2 25 3 50 4 70 80 6 85 7 86
As additional workers are hired output increases at a decreasing rate
The additional output, i.e., Marginal Product, declines
This is referred to as the law of Diminishing Marginal Product
Assume price= $0.5 - 5 20 25 10 1 -
2.5 10
12.5 5
0.5

20. 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

21. Labor Demand If W=2.5, How many workers will be hired?
The labor demand curve is the downward sloping part of the MRP curve
MRP 5
Labor
Demand
2.5 1 5 6
Quantity of
Labor

22. 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

23. How the Minimum Wage Affects the Labor Market
Supply
Labor
demand
Labor surplus
(unemployment)
Minimum
wage
Quantity
demanded
Quantity
supplied
Equilibrium
wage
Quantity of
Labor

24. 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

25. 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.

26. TAXES Governments levy taxes to : raise revenue for public projects
Change market price to reduce trade in a particular good 20 29

27. 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. 21 31

28. 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. 21 31

29. A Tax on Sellers Price Demand, D1 Price buyers pay S1 3.00 100 Price
Sellers get
Quantity of
Ice-Cream Cones

30. A Tax on Sellers Price Demand, D1 A tax on sellers shifts the supply
curve upward
by the amount of
the tax ($0.50). S2 S1
$2.50
Tax ($0.50)
2.00 50
Quantity of
Ice-Cream Cones

31. A Tax on Sellers Price of Ice-Cream Demand, D1 Cone S2 S1 $3.30 90
𝑃 𝐵 S1
$3.30 90
Tax ($0.50)
Price
Before tax
3.00
100
2.80
𝑃 S
Quantity of
Ice-Cream Cones

32. 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.

33. Effects of a tax
Losers: both buyers and sellers, regardless of who the tax is imposed on
Winners: government revenue
The tax results in a reduction in quantity
Price D S
Price buyers
pay ($3.3)
Tax wedge
($0.5)
Price
without tax
Price sellers
Receive
($2.8) Qt
Quantity