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. 2 2

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

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 4 4

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

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

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

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

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

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

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

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

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

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

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 Wage Labor demand Quantity of Labor

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

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

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? 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

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 Supply Labor demand Labor surplus (unemployment) Minimum wage Quantity demanded Quantity supplied Equilibrium wage 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 20 29

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

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

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

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

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

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 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