C11

University Lecture Notes: Economics of Government Interventions - Price Controls, Subsidies, and Taxation

Course Reminders and Introduction to Government Interventions

• Administrative Announcements:

  • Seminar Rescheduling: The seminar originally scheduled for today has been moved to next Friday.

  • Upcoming Session: On Friday the $21^{st}$, the class will focus on the solutions for Problem Set Number Two.

• Main Topic Overview: The lecture covers government interventions in the market, specifically focusing on policies that modify market outcomes through:

  • Price Controls: Including price ceilings and price floors.

  • Taxes: Analyzing direct and indirect taxation.

  • Subsidies: Welfare and fiscal impacts of government support.

• Analytical Framework: The analysis of these interventions relies on two primary economic toolsets developed earlier in the course:

  • Elasticity: Both supply and demand elasticities are crucial for determining the severity of market imbalances (shortages or surpluses) and the incidence of taxes.

  • Surplus Analysis: Utilizing Consumer Surplus ($CS$) and Producer Surplus ($PS$) to quantify the welfare effects of policy shocks and interventions on buyers, sellers, and society as a whole.

Price Controls: Price Ceilings and Rent Control

• Definition of a Price Ceiling: A government-imposed maximum price at which a good can be sold. For a price ceiling to be binding, it must be set below the natural market equilibrium price ($P_{ceiling} < P_E$).

• Impact of Binding Price Ceilings: The primary result of a binding price ceiling is a shortage, also known as excess demand.

• Rent Control Case Study:

  • Mechanism: The government sets a maximum rent ($P_R$) below the equilibrium rent ($P_E$).

  • Short-Term vs. Long-Term Effects: The shortage created by rent control becomes more severe over time because both supply and demand are more elastic in the long term.

  • Long-Term Elasticity: In the long run, landlords have more time to withhold units or convert them to other uses, and tenants have more time to search for apartments, increasing the responsiveness to price changes.

• Numerical/Graphical Welfare Analysis of Rent Control:

  • Benchmark Portfolio: The competitive market equilibrium is used as the Pareto optimal/efficient reference point.

  • Quantity Traded: Under rent control, the quantity rented ($Q_R$) is determined by the short side of the market; you cannot force landlords to supply more than they are willing to at price $P_R$. Thus, $Q_R$ is the quantity supplied at the lower price.

  • Surplus Components at Equilibrium:

    • Initial Consumer Surplus ($CS_{initial}$): Area $A + B + C$.

    • Initial Producer Surplus ($PS_{initial}$): Area $D + E + F$.

  • Surplus Components under Rent Control:

    • New Consumer Surplus ($CS_{new}$): Area $A + B + D$. (Assuming consumers who find housing pay lower prices; area $D$ is a transfer from producers).

    • New Producer Surplus ($PS_{new}$): Area $F$.

  • Net Changes and Deadweight Loss ($DWL$):

    • Change in $CS$: $D - C$. (Ambiguous: winners are those who keep renting at lower prices; losers are those who lose access to housing entirely).

    • Change in $PS$: $-(D + E)$. (Landlords are definite losers due to lower rents and fewer units rented).

    • Total Welfare Effect ($\\Delta Surplus$): $-(C + E)$. This represents the Deadweight Loss—the loss to society due to foregone consumption and production.

• The Geneva Context:

  • Geneva maintains a form of rent control where landlords cannot set rents higher than the average of equivalent apartments in the neighborhood.

  • Consequence: Geneva has one of the lowest vacancy rates in Switzerland.

  • Inefficiency Example: Tenants stay in large apartments they no longer need (e.g., after children move out) because they cannot find smaller apartments at similar low prices, a behavior the market cannot easily prevent due to information asymmetry.

• Uber Analogy: The professor notes that the welfare analysis of preventing Uber price surges (price search) is identical to the rent control analysis.

Policy Alternatives: Subsidies on the Supply Side

• Objective: To lower prices for consumers without creating the shortages associated with price ceilings.

• Mechanism: The state provides a payment to sellers for every unit sold, effectively shifting the supply curve to the right.

• Welfare Analysis of Subsidies:

  • Equilibrium: The price paid by consumers decreases, while the price received by producers (including the subsidy) increases.

  • Consumer Surplus Change: Positive, represented by Area $C + F$.

  • Producer Surplus Change: Positive, represented by Area $B + E$.

  • Government/Fiscal Cost: This is the major drawback. The total cost to the state is $Unit\,Subsidy \times Quantity\,Traded$. This is a massive area on the graph (e.g., all areas between the two supply curves up to the new quantity).

  • Deadweight Loss of Subsidy: Despite increasing quantity, subsidies still create a $DWL$ of Area $-(G + H)$ because the cost to the government exceeds the total surplus gains of consumers and producers.

• Political Economy Note: Governments often prefer rent controls over subsidies because rent controls have no direct fiscal cost to the state budget, even though they create greater market distortions.

Market Structure Considerations: Why Competitive Models Might Fail

• Housing Market Characteristics: The professor acknowledges that housing is not a perfectly competitive market due to:

  1. Heterogeneity: Housing is not a homogeneous good.

  2. Asymmetry of Information: Buyers and sellers do not have equal information.

  3. Market Power: Landowners often hold significant market power.

• Equity and Justice: Government interventions are often motivated by equity concerns (e.g., housing representing a high share of expenditure for low-income households) rather than pure market efficiency.

Price Floors: The Minimum Wage

• Definition: A price floor is a government-imposed minimum price. In the labor market, it is the minimum wage ($W_{min}$). For it to be binding, it must be above the equilibrium wage ($W_{min} > W_E$).

• Market Agents:

  • Supply Side: The workers (providing labor).

  • Demand Side: The firms (buying labor).

• Standard Competitive Analysis:

  • Result: A binding minimum wage creates an excess supply of labor, also known as unemployment. Fewer workers are hired because firms (the short side) decide the employment level at the higher wage.

  • Welfare Effects:

    • Initial $PS$ (Workers): $D + E + F$.

    • Initial $CS$ (Firms): $A + B + C$.

    • New $PS$ (Workers): $B + D + G$. (Change is $B - F$).

    • New $CS$ (Firms): $A$. (Change is $-(B + C)$).

    • Deadweight Loss: Area $-(C + F)$.

• The Monopsony Counter-Argument:

  • The Card and Kruger Study: A famous natural experiment comparing New Jersey (which increased the minimum wage) to Pennsylvania (which did not).

  • Finding: Contrary to competitive theory, employment actually increased in New Jersey.

  • Explanation: Many labor markets act as a Monopsony (market power on the buyer/firm side). Firms voluntarily restrict hiring to keep wages low. Introducing a minimum wage can strip this market power, moving the market along the supply curve and actually increasing both wages and employment simultaneously.

Principles of Indirect Taxation

• Direct Taxation: Levied on individuals' revenue (e.g., personal income tax, typically paid in June or end of year).

• Indirect Taxation: Levied on the exchange of goods and services, independent of the individual's income.

  • VAT/TVA Example: The Value Added Tax is the primary indirect tax.

  • Swiss Rates: General rate is $7.7\%$; essential goods (food, books, water) have a reduced rate of $2.5\%$.

• Key Taxation Concepts:

  1. Tax Burden: The total decline in welfare/surplus resulting from the tax distortion.

  2. Tax Incidence: How the burden of the tax is shared between buyers and sellers. This depends on Relative Elasticity. The more inelastic side of the market will bear more of the tax incidence because they are less able to adjust their behavior.

  3. Tax Wedge: The tax creates a gap between the price paid by the buyer ($P_B$) and the price received by the seller ($P_S$). Precisely: $Tax = P_B - P_S$.

• Tax Neutrality Regarding Statutory Responsibility:

  • Tax on Buyers: Graphically represented by a downward shift of the demand curve by the tax amount.

  • Tax on Sellers: Graphically represented by an upward shift of the supply curve by the tax amount.

  • Conclusion: The final impact on quantity exchanged and prices is identical regardless of who is legally required to pay the tax to the government.

Questions & Discussion

• Question: Why do people stay in big apartments in Geneva?

• Response: Because the rent control structure makes it difficult to find smaller, cheaper apartments. Since prices are not allowed to reach equilibrium, there is no incentive or availability for people to downsize, leading to a "lock-in" effect.

• Question: If the minimum wage is low, how does it help the economy if people don't earn enough to live?

• Response: This is a macroeconomics question to be addressed next semester. However, from a micro perspective, the introduction of a minimum wage in a monopsonistic market allows workers to earn more than they otherwise would have if the firm exerted full market power.

Mandatory Homework Exercises

• Analytical Exercise: Using the standard coffee supply and demand example, calculate the new equilibrium price and quantity if the government introduces a tax of $\$6$.

  • Scenario A: Tax is collected from sellers.

  • Scenario B: Tax is collected from buyers.

• Incidence Thinking: Evaluate which agent (buyer or seller) suffers more from the tax based on graphical shifts and relative slopes.