Supply, Demand, and Government Policies: Price Controls and Taxes
Chapter 6: Supply, Demand, and Government Policies
Controls on Prices
Definition: Policymakers may impose price controls when they believe the market price of a good or service is unfair to either buyers or sellers. However, these controls can generate inequities.
Types of Price Controls:
Price Ceiling:
A legal maximum on the price at which a good can be sold.
Example: Rent-control laws.
Effects on Market Outcomes:
Not Binding: If the price ceiling is set above the equilibrium price, it has no effect on the market price or the quantity sold.
Binding Constraint: If the price ceiling is set below the equilibrium price, it creates a shortage.
When a shortage occurs, sellers must ration the scarce goods.
Common rationing mechanisms include long lines (e.g., for gasoline) or discrimination based on sellers' biases.
Case Study: Lines at the Gas Pump (1973)
In 1973, OPEC (Organization of the Petroleum Exporting Countries) significantly raised the price of crude oil, leading to a reduction in the supply of gasoline, which would naturally cause higher prices and potentially shortages.
The U.S. government had previously imposed a price ceiling on gasoline.
Before OPEC's action: The equilibrium price of gasoline was below the price ceiling, so the ceiling was non-binding and had no effect.
After OPEC's action: The decrease in crude oil supply caused the equilibrium price of gasoline to rise above the existing price ceiling.
Result: The price ceiling became a binding constraint, leading to a severe shortage of gasoline and long lines at gas stations.
The laws regulating the price of gasoline were eventually repealed to allow market prices to clear.
Case Study: Rent Control
Definition: A local government places a legal maximum (price ceiling) on rents.
Goal: To help the poor by making housing more affordable.
Critique: Many economists view rent control as a highly inefficient way to help the poor raise their standard of living.
Adverse Effects:
In the Short Run:
Supply and demand for housing are relatively inelastic in the short run (people's housing needs and landlords' ability to build/convert are fixed).
Results in a small shortage and reduced rents for those who secure housing.
In the Long Run:
Supply and demand for housing become more elastic.
For Landlords: They lose the incentive to build new apartments or adequately maintain existing ones (e.g., if maintenance costs exceed potential revenue under the ceiling).
For People: Lower rents induce more people to seek housing in the city, and existing residents might not move as readily.
Result: A large shortage of housing develops, and the quality of housing declines.
Rationing Mechanisms: Since prices cannot allocate resources, other, often undesirable, rationing methods emerge:
Long waiting lists for apartments.
Landlords may show preference to tenants without children or discriminate based on race or other biases.
Tenants might resort to bribing building superintendents.
Incentives: Free markets incentivize landlords to maintain clean and safe buildings to attract tenants at higher prices. Rent control removes these incentives, leading to lower quality housing.
Policymaker Response: To mitigate declining quality, policymakers often impose additional regulations, which are difficult and costly to enforce.
Ask the Experts (Part 1 - Rent Control): An expert statement suggests that local ordinances limiting rent increases in cities like New York and San Francisco have had a positive impact over the past three decades on the amount and quality of broadly affordable rental housing. This opinion may contrast with the general economic analysis provided.
A figure (Figure 3) illustrates rent control's effects in both the short and long run, showing how the shortage becomes more pronounced over time due to increasing elasticity.
Price Floor:
A legal minimum on the price at which a good can be sold.
Example: Minimum wage laws.
Effects on Market Outcomes:
Not Binding: If the price floor is set below the equilibrium price, it has no effect on the market.
Binding Constraint: If the price floor is set above the equilibrium price, it creates a surplus.
Some sellers are unable to sell what they want (e.g., workers cannot find jobs).
This leads to undesirable rationing mechanisms (e.g., unemployment).
Case Study: The Minimum Wage
Definition: The lowest price for labor that any employer may legally pay.
Purpose: Established by laws like the Fair Labor Standards Act of 1938, aiming to ensure workers a minimally adequate standard of living.
Current Federal Minimum Wage: In 2018, the federal minimum wage was 7.25$/hour. Some states mandate minimum wages above this federal level.
International Comparison: In France, where the average income is 30\% lower than in the U.S., the minimum wage is more than 30\% higher than the U.S. federal minimum wage.
Labor Market Dynamics:
Workers supply labor.
Firms demand labor.
Impact of a Binding Minimum Wage (above equilibrium wage):
Leads to unemployment (a surplus of labor).
Results in higher income for workers who retain or find jobs at the minimum wage.
Results in lower income for workers who are unable to find jobs due to the wage floor.
Impact on Different Worker Groups:
Highly Skilled and Experienced Workers: The minimum wage typically has no effect on these workers because their equilibrium wages are usually well above the minimum wage, making the minimum wage non-binding for them.
Teenage Labor: This group is often the least skilled and least experienced, with naturally low equilibrium wages.
They may be willing to accept a lower wage in exchange for valuable on-the-job training.
For this group, the minimum wage is often binding, leading to a significant impact.
Studies suggest that a 10\% increase in the minimum wage can depress teenage employment between 1\% and 3\%.
A binding minimum wage can also incentivize some high school students to drop out for jobs, potentially displacing other teenagers who had already left school and now face unemployment.
Advocates of the Minimum Wage:
Argue that it helps raise the income of the working poor, many of whom otherwise might only afford a meager standard of living.
Opponents of the Minimum Wage:
Contend that it is not the best way to combat poverty due to its unintended consequences:
Causes unemployment.
Encourages teenagers to drop out of school.
Prevents some unskilled workers from gaining valuable on-the-job training.
They often describe it as a poorly targeted policy.
Ask the Experts (Part 2 - Minimum Wage): An expert states that if the federal minimum wage is raised gradually to 15$-per-hour by 2020, the employment rate for low-wage U.S. workers will be substantially lower than it would be under the status quo. This aligns with the opponents' arguments.
A figure (Figure 5) illustrates how the minimum wage affects the labor market, creating a surplus of labor (unemployment) when binding.
Evaluating Price Controls
Economists' Stance: Generally, economists oppose price ceilings and price floors because they believe markets are usually a good way to organize economic activity.
Prices are not arbitrary; they perform the crucial function of balancing supply and demand, thereby coordinating economic activity efficiently.
Government Intervention: Governments sometimes want to use price controls due to perceived unfair market outcomes, often aiming to help the poor.
Consequences: Despite good intentions, price controls often hurt those they are trying to help due to market distortions.
Alternative Ways to Help Those in Need: Instead of price controls:
Rent subsidies: Provide financial assistance directly to low-income tenants, allowing them to afford market-rate housing without distorting the rental market.
Wage subsidies (e.g., Earned Income Tax Credit): Augment the income of low-wage workers without interfering with the labor market's wage structure, thus avoiding unemployment.
Taxes
Purpose of Taxes: Governments use taxes for two primary reasons:
To raise revenue for public projects (e.g., roads, schools, national defense).
To influence market outcomes (e.g., discourage consumption of certain goods).
Tax Incidence: Refers to the manner in which the burden of a tax is shared among participants in a market (buyers and sellers).
How Taxes on Sellers Affect Market Outcomes
Immediate Impact: A tax on sellers immediately affects the supply decisions, effectively increasing their cost of production. This causes the supply curve to shift left (or upward).
Market Outcomes:
Higher equilibrium price (buyers pay more).
Lower equilibrium quantity (reduced market size).
The tax generally discourages overall market activity.
Burden Sharing: Buyers and sellers share the burden of the tax.
Buyers pay a higher market price, making them worse off.
Sellers receive a higher market price but, after paying the tax, their effective price (the price they get to keep) falls, making them worse off.
A figure (Figure 6) illustrates the effect of a tax on sellers, showing the supply curve shifting left and the new equilibrium.
How Taxes on Buyers Affect Market Outcomes
Initial Impact: A tax on buyers directly affects their willingness to pay, effectively decreasing the value they place on the good. This causes the demand curve to shift left (or downward).
Market Outcomes:
Lower equilibrium price (sellers receive less).
Lower equilibrium quantity (reduced market size).
The tax also discourages overall market activity.
Burden Sharing: Buyers and sellers share the burden of the tax.
Sellers get a lower market price, making them worse off.
Buyers pay a lower market price, but when the tax is added, their effective price (the total cost incluindo the tax) rises, making them worse off.
A figure (Figure 7) illustrates the effect of a tax on buyers, showing the demand curve shifting left and the new equilibrium.
Equivalence of Taxes on Buyers and Sellers
Key Insight: Taxes levied on sellers and taxes levied on buyers are ultimately equivalent in terms of their market impact.
Wedge: Both types of taxes create an identical