1. Government Control of Prices in What Are the Actual Outcomes?
Chapter 3
Government Control of Prices in
Mixed Systems:
What Are the Actual Outcomes?
McGraw-Hill/Irwin
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

2. Key Concepts Price ceilings Price floors Rent controls Minimum wages
Shortages
Surpluses
Derived demand
Marginal product of labor
Marginal revenue
Substitution effect
Income effect

3. Price Ceiling and Price Floor
Price ceiling is the maximum allowable price for a good or service set by the government or a group of sellers
Holding inflation in check
Keeping prices affordable for poorer part of population
Price floor is the minimum allowable price for a good or service set by the government or a group of sellers
Minimum wage laws

4. Rent Controls Why would people live in slums?
Do the rent controls serve best interests of low-income groups?
What are the ways out of the poor’s housing problems?

5. Demand for Housing
Each household allocates its income in such a way that a dollar’s worth of housing contributes the same to its well-being as a dollar’s worth of anything else it buys
At the a level that is higher than the equilibrium one, a dollar’s worth of housing is a smaller quantity of housing than before
Alternatively, an additional dollar’s worth of housing contributes less to the household’s well-being than before
The contribution of an additional dollar to buying anything else but housing is greater than before
Rational households will thus shift their consumption away from housing and into something else
The decrease in demand for housing happens due to:
Sharing
Moving in back with families
Relocating further away

6. Supply of Housing
Supply for housing is not very responsive to movements in price
As a result, the supply curve is relatively sharp
It takes several years to significantly increase the existing stock of housing

7. Supply and Demand for Housing
Rent per unit $ S D B
600 A
500
400 8 10 11
Quantity (thousands of units per year)

8. Housing Prices
Suppose economic growth and rising housing rentals shift the demand curve for housing outwards (to the right)
Given the inability to build new housing units quickly, housing prices will rise fairly fast in the short run
Rise in rental rates makes investment in housing more profitable
As a result, the supply curve for housing will shift to the right in the long run
Since typically housing demand outpaces the growth in housing supply, the outcome will be characterized by
Greater amount of housing available
Higher rental rates

9. Rent Control
Rent per unit $ S1 D1 D S
800
600
525
500 10 11
12.5 13
Quantity (thousands of units per year)

10. Effects of Rent Controls
What are the actual effects of rent controls?
Most important effect of rent controls is housing shortage
If the rent controls are set below the equilibrium level, not all households looking for apartments are able to find them
Under-the-table payments
Housing costs increases for commuters:
Direct costs of commuting
Value of time lost in commuting
The long-run profit inducements that would shift the supply curve for housing outwards are eliminated by rent controls
Homeless population increases due to the decreased supply
Landlords tend to allow the quality of their housing units to deteriorate
The price of housing no longer reflects the value of housing for the households  misallocation of resources

11. Minimum Wages Most people view favorably the laws on minimum wages
What are the economic effects of the minimum?
Does the minimum serve to improve the distribution of income in the country?
We need to address the way in which the labor market functions to answer these questions

12. Market Demand for Labor
Derived demand for labor: The demand for labor is said to be dependent on, or derived from, the demand for the product being produced
Employers do not demand labor because they receive direct satisfaction from labor but because employing labor leads to satisfaction indirectly in the form of increased revenues when employers sell the products produced by labor
As more labor is hired, the value of an additional worker to the employer declines  the downward-sloping demand curve for labor

13. Minimum Wages - Market Demand for Labor
Wage rate ($) D
4.00
3.50
3.00
2.50
2.00
1.50
1.00
.50 D
(Quantity (thousands of hours per week)
3-13

14. Demand for Labor by One Employer
Marginal revenue product of labor: the increase in revenue that accrues to the firm when an additional worker is hired, indicating the value of the worker to the firm
Marginal product of labor: the increase in revenue from selling an additional unit of the product
Law of diminishing returns: as additional units of a variable input are added to a given amount of a fixed input, the resulting increases in output eventually will decline

15. The Demand for Labor by One Employer
(1)
(2)
(3)
(4)
(5)
Units of Labor
Total Production
Marginal Product
Marginal Revenue
Marginal Revenue Product
MRP = (3) x (4) 1 5
$.50
$2.50 2 25 20
10.00 3 50
12.50 4 70 80 10
5.00 6 85
2.50 7 86
.50
3-15

16. The Demand for Labor by One Employer
Rational Demand for Labor
12.50
10.00
5.00
2.50
.50 1 2 3 4 5 6 7
Quantity of Labor

17. Demand for Labor
Benefits of specialization result in increasing marginal product of labor when a few people are hired
Diminishing returns to labor, however, eventually come into being
Firms typically have a fixed number of tools so increasing employment means sharing tools and their inefficient use
“Too many cooks spoil the broth”
Overspecialization leads to workers being bored, distracted and less efficient

18. Marginal Product, Revenue and Revenue Product
Initial increase of marginal product: with only one worker there is too little labor for the amount of capital that the firm has at its disposal (the firm’s capital is underutilized)
Hiring the second worker allows to use capital more efficiently
Capital can be overutilized as well, leading to the decreasing marginal product of labor (“too many cooks spoil the soup”)
Overspecialization of labor can also result in diminishing returns

19. Market Supply of Labor
The supply curve of labor tells us what happens to the hours of work offered by an economy’s workers as the wage changes
Does the amount of working hours increase as the wage increase?
Substitution effect: the change in the hours of work that occurs in response to a wage change, other things being equal (wage is price of leisure, so that rising wages result in more working hours)
Income effect: a measure of the change in the hours of work that occurs when there is a change in income, other things being equal (income effect treats leisure as a normal good, demand for leisure increasing as income increases)

20. Market Supply of Labor Substitution Effect Income Effect Wage rate ($)
4.00
3.50
3.00
2.50
2.00
1.50
1.00
.50
Substitution Effect
Income Effect S
Quantity (thousands of hours per week)

21. Effects of Wage Increase
An increase in wages results in increased demand for leisure since leisure is a normal good
As a result, the supply curve of labor due to income effect alone should be negatively sloped
However, the substitution effect (leisure versus income) dominates, so that the supply curve for labor is normally positively sloped

22. Effects of Minimum Wage
If the wage rate is higher than the marginal revenue product of labor, the employers will higher less labor
Whenever minimum prices are set above the market equilibrium, they result in a surplus called unemployment
Effects of minimum wages
Quantity of labor demanded falls
Quantity of labor supplied increases

23. Effects of the Minimum Wage
Wage rate ($) D S
6.00
5.00 S D
8.5 9
9.25
Quantity (thousands of hours per week)

24. Minimum Wages and Poverty
Is the minimum wage an effective antipoverty tool?
By how much do minimum wages increase unemployment?
To what extent does the minimum wage improve distribution of income in the economy?

25. Minimum Wages and Poverty
The minimum had fallen to only 36% of average earnings
As an antipoverty tool, the minimum is not particularly potent
Unemployment effects of minimum wages are unclear

26. Alternative Analysis of the Minimum Wage
Wage rate ($) D
6.00
5.00 S D 9
Quantity (thousands of hours per week)

27. Alternative Analysis of the Minimum Wage
Vertical portion of the demand curve
Higher wages are offset by longer queues
Improvements in operating efficiency
Raising prices on items with inelastic demand
Avoiding hiring and training costs
Vertical portion of the supply curve
For low wage earners, the number of hours worked may be more important than the wage rate
Income and substitution effects exactly offset each other
Minimum wages may have little or no effect as long as we are on the vertical part of the demand and supply curve