Transcript Chapter 3
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
Rent
Demand
0
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
0
Quantity
Equilibrium
An increase in demand
Rent
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
S1
S2
D2
D1
0
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
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
$500
400
Rent
Control
Shortage
Demand
0
9
Quantity
supplied
11
Quantity
demanded
Quantity
Effect of Rent Control
Rent
Rent is not low for everyone
Supply
Since a rent higher than
$400 is illegal, the market
cannot work to allocate the $500
housing units among people.
Illegal payments to landlords
400
Rent is higher in non rent
controlled areas
0
Rent
Control
Shortage
Demand
9
Quantity
supplied
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?
Demand for labor is downward
sloping
Demand for labor is a derived
demand
Wage
Labor 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, which
is the marginal benefit of
hiring that worker
Labor
Total
Product
0
0
1
5
2
25
3
50
4
70
5
80
6
85
7
86
Marginal
Product
MRP
Deriving Labor Demand
Labor
Total
Product
hired output increases at a
decreasing rate
The additional output, i.e.,
Marginal Product, declines
0
0
2
50
This is referred to as the law
3
of Diminishing Marginal
Product
As additional workers are
Assume price= $0.5
Marginal
Product
MRP
-
-
30
15
20
10
65
15
7.5
4
79
14
7
5
84
5
2.5
6
86
2
1
1
30
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?
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
Wage
Labor surplus
(unemployment)
Labor
Supply
Minimum
wage
Equilibrium
wage
Labor
demand
0
Quantity
demanded
Quantity
supplied
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, 𝑃𝐵 .
The price that sellers receive, 𝑃𝑆 .
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
S1
3.00
Price
Sellers get
Demand, D1
0
100
Quantity of
Ice-Cream Cones
A Tax on Sellers
Price
S2
S1
$2.50
A tax on sellers
shifts the supply
curve upward
by the amount of
the tax ($0.50).
Tax ($0.50)
2.00
Demand, D1
0
50
Quantity of
Ice-Cream Cones
A Tax on Sellers
Price of
Ice-Cream
Cone
S2
𝑃𝐵
Price
Before tax
$3.30
3.00
2.80
S1
Tax ($0.50)
𝑃S
Demand, D1
0
90
100
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
Price
S
Price buyers
pay ($3.3)
Price
without tax
Winners:
government revenue
Tax wedge
($0.5)
The tax results in a
reduction in quantity
Price sellers
Receive
($2.8)
D
0
Qt
Quantity
How the Minimum Wage Affects the
Labor Market
Wage
Labor demand
Labor
Supply
7
5
0
50
70
Quantity of
Labor