Government Price Control Policies and Economic Efficiency

What we will learn in this class Why does the government need price control policies? Two price control policies: price ceiling and price floor. Impacts of government price control policies on market outcomes. Lessons that we can learn from government price policies.

Why does the government want to regulate market prices? A competitive market free of government regulations is efficient when it is at equilibrium. However, some suppliers or demanders may not be satisfied with the market equilibriums. As a result of such dissatisfaction, they may try to lobby the government to impose price control policies.

What kind of price control policies the government may adopt? Price ceiling (if demanders win): is a legally determined maximum price that sellers may charge. Price floor (if suppliers win): is a legally determined minimum price that sellers may receive.

Impacts of government price control policies on market Price ceiling: Example: Rent control Price floor: Example: Minimum wage

Price Ceiling: Rent Control in New York City It dates back to the housing shortage following World War II and generally applies to buildings constructed before 1947 in New York City. Rent control is intended to protect tenants in privately-owned buildings from illegal rent increases.

Price Ceiling: Rent Control The Market for Apartments without Price Ceiling Q Rental price of apts S D $800 300 Equilibrium without price controls We start by analyzing the effects of a price ceiling. The most common example is rent control, so we do the analysis in the context of this example. We begin by showing the market for apartments in equilibrium (before the government imposes any price controls). Quantity of apartments

Price Ceiling: Rent Control The Market for Apartments with Price Ceiling that is binding Q S The eq’m price ($800) is above the ceiling and therefore illegal. The ceiling is a binding constraint on the price, and causes a shortage. D $800 Price ceiling $500 250 400 shortage In this case, the price ceiling is binding. In the new equilibrium with the price ceiling, the actual price (rent) of an apartment will be $500. It won’t be more than that, because any higher price is illegal. It won’t be less than $500, because the shortage would be even larger if the price were lower. The actual quantity of apartments rented equals 250, and there is a shortage equal to 150 (the difference between the quantity demanded, 400, and the quantity supplied, 250.

Effects of A Binding Rent Control A binding rent control creates a shortage of apartments: long waiting lists. Non-price rationing: more low income families may not be able to find an apartment to rent. It also encourages Black Market.

Summary: market outcomes of government price ceiling policy Price ceiling reduces market efficiency (shortage). Non-price rationing. In contrast, a competitive equilibrium market without price controls is more efficient.

Price Floor: Minimum Wage Minimum wage in Pennsylvania has risen to $6.25 starting Jan. 1, 2007 and will continue to increase to $7.15 on July 1, 2007. It has been designed to protect those with low skills, low education and teenager workers.

Price Floor: Minimum Wage Unskilled labor market without minimum wage Wage paid to unskilled workers S D $4 500 Eq’m w/o price controls Now we switch gears and look at the effects of a price floor. We illustrate this concept using the common textbook example – the minimum wage. This may be the first time students have seen a supply-demand diagram of the labor market. It might be useful to note that the “price” of labor is more commonly known as the wage, which we measure on the vertical axis of our supply-demand diagram. Along the horizontal axis, we measure the quantity of labor (number of workers). The demand for unskilled labor comes from firms. The supply comes from workers. We focus on unskilled labor because the minimum wage is not relevant for higher skilled, higher wage workers. Quantity of unskilled workers

Price Floor: Minimum Wage Unskilled labor market with a binding minimum wage labor surplus W L S The equilibrium wage ($6) is below the floor and therefore illegal. The floor is a binding constraint on the wage, and causes a surplus (i.e., unemployment). Price floor $7.15 D 400 550 $6 Now, the minimum wage exceeds the equilibrium wage. The equilibrium wage (or any wage below $5) is illegal. In this case, the actual wage will be $5. It will not be lower, because any lower wage is illegal. It will not be higher, because at any higher wage, the surplus would be even greater. The actual number of unskilled workers with jobs equals 400. 550 want jobs, but firms are only willing to hire 400, leaving a surplus (i.e. unemployment) of 150 workers. A surplus of anything – especially labor – represents wasted resources.

Market Outcomes of A Binding Minimum Wage A binding minimum wage creates a surplus of unskilled workers. (more unemployment). non-price rationing: employers may discriminate certain types of job applicants. more labor supply from teenagers: people in need may end up losing jobs.

Summary: Market outcomes of government price floor policy Price floor reduces market efficiency (surplus). Non-price rationing. In contrast, the competitive equilibrium market without price floor is more efficient.

Lessons that we can learn from government price control policies Price plays a very crucial role in our economy. Controlling price may reduce market efficiency and may miss the policy intentions. Alternative government policies.

Tax

Content Tax Tax on buyer side Tax on seller side Applications

Tax incidence: distribution of tax Importance of tax Tax incidence: distribution of tax When a new tax is imposed, who will pay it? What’s the market outcomes?

When A New Tax Is Imposed on Buyers Tax on Cigarettes

Step one Step two Step three Tax shift demand curve? How demand curve shifts? Step three Compare two equilibriums

Elasticity and tax on buyers Implications If the government levies a tax on buyers Taxes reduce quantity of good sold Buyers and sellers share the burden of taxes Elasticity and tax on buyers

When A New Tax Is Imposed on Sellers Taxes on oil companies BP took in 250 billion revenue last year

Step one Step two Step three A tax will shift supply curve? How? Compare two equilibriums

If the government levies a new tax on sellers Implications If the government levies a new tax on sellers A new tax will discourage market activities, reducing quantity of goods sold. Sellers and buyers share the burden of taxes Elasticity and tax on sellers