Chapter 3

Government Control of Prices in Mixed Systems

Supply, Demand, and Government PoliciesIn 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 supplySometimes the government sets a minimum or a maximum price for certain goods.

222CONTROLS ON PRICESAre usually enacted when policymakers believe the market price is unfair to buyers or sellers. Examples: price ceilings and floors. 333Are 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 governments policies which in many cases weakens the effect of the policyUnexpected and negative consequences result from government interventionCONTROLS ON PRICESPrice 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 individualsUsed in many cities to keep housing costs downIn 1970 more than 200 US cities enacted some form of rent control544CONTROLS ON PRICESPrice FloorA legal minimum on the price at which a good can be sold.Typically used to benefit the sellers of a certain goodThe 1938 Fair Labor Standards Act established the first federal minimum wage lawsMinimum wage laws were widely supported as a means to maintaining the minimum standards of living644Rent ControlRent 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.

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Demand for HousingQuantity0RentDemandThe demand curve shows the total number of housing units demanded at each priceDemand is downward slopingAs the rental price increases, households substitute away from housing bySharing housing units with othersConsuming smaller housing units Housing demand is inelastic in the short run

Supply for HousingQuantity0RentThe supply curve shows the total number of housing units supplied at each priceSupply is upward slopingAs the rental price increases, more housing units will be available throughConstruction of new units (long run)Conversion from other uses (short run)Housing supply is inelastic in the short runSupply

EquilibriumQuantity0RentAn increase in demand results in a higher rental price and an increase in quantity supplied of rental apartmentsIn the long run, new housing units are constructed as investment in housing becomes more profitable and the supply shifts rightS1D1D2S2Rent ControlRent 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 groupsWhat are the actual effects?

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Effect of Rent ControlQuantity0RentDemandSupply400RentControlShortage9Quantitysupplied11Quantitydemanded$500A shortage results, which grows with increasing demandPeople are forced to delay the decision to move out of rent controlled units or to add to their living space.

Effect of Rent ControlQuantity0RentDemandSupply400RentControlShortage9Quantitysupplied11Quantitydemanded$500Rent is not low for everyoneSince a rent higher than $400 is illegal, the market cannot work to allocate the housing units among people.Illegal payments to landlordsRent is higher in non rent controlled areas Effect of Rent ControlNo incentives to construct new housing units as it becomes less profitableHousing supply shrinks in the long run as some home builders exit the marketFewer rent controlled housing units which contributes to homelessness

142Effect of Rent ControlHousing quality deteriorates as landlords have less incentives to maintain themResource misallocation occurs as goods of value are underprovided since the price is not allowed to reflect housing value.

152Minimum 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 scaleQuestions:Who benefits?Effects on the labor market? on poverty?Objective: Understand how wage is determined in a free market

Labor DemandQuantity ofLaborWageLabordemandDemand for labor is downward slopingDemand for labor is a derived demand

Deriving Labor DemandWhen an additional worker is hired, production increases and thus the total revenue of the firm increasesThis increase in revenue is called the marginal revenue product, which is the marginal benefit of hiring that worker

LaborTotalProductMarginal ProductMRP0015225350470580685786

Deriving Labor DemandAs additional workers are hired output increases at a decreasing rateThe additional output, i.e., Marginal Product, eventually declinesThis is referred to as the law of Diminishing Marginal ProductAssume price= $0.5

LaborTotalProductMarginal ProductMRP0015225350470580685786-

5

20

25

20

10

5

1-

2.5

10

12.5

10

5

2.5

0.5

Deriving Labor DemandThe cost of hiring an extra worker is the wage, WThe 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: MRP >=W

Labor DemandQuantity ofLaborMRPIf 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

2.51655Labor DemandLabor Supply

What will happen to the number of hours worked as the wage rate increases?Time allocate between work and leisureSubstitution effect: work more consume less leisureIncome effect: higher income leads to consuming more leisure and working less

General Conclusion: Labor supply is upward slopingHow the Minimum Wage Affects the Labor MarketQuantity ofLaborWage0LaborSupplyLabor surplus(unemployment)LabordemandMinimumwageQuantitydemandedQuantitysuppliedEquilibriumwageThe 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

How the Minimum Wage Affects the Labor Market

Who gets to work at the minimum wage?The answer will determine the distributional impact of the policyResearch 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 poolSimilarly for women and minorities.

TAXESGovernments levy taxes to :raise revenue for public projectsChange market price to reduce trade in a particular good 262920How Taxes Affect Market OutcomesTax 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.

273121How Taxes Affect Market Outcomes2831210.80Quantity ofIce-Cream Cones0PricePriceSellers acceptbefore the taxTax ($0.50)Price sellers accept under the taxS1S2A tax on sellersshifts the supplycurve upwardby the amount ofthe tax ($0.50).30Demand, D13.00100A Tax on Sellers1.30A Tax on Sellers2.80Quantity ofIce-Cream Cones0Price ofIce-CreamConePriceBefore taxTax ($0.50)S1S2Demand, D13.00100$3.3090A 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 sellersThe 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 taxQuantity0Price DSTax wedge($0.5)Price sellersReceive($2.8)Price buyers pay ($3.3)Price without taxQt Losers: both buyers and sellers, regardless of who the tax is imposed on

Winners: government revenue

The tax results in a reduction in quantity