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.
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
Demand for Housing The demand curve shows the Rent 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 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 Suppl y 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
Effect of Rent Control Ren t 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 Shortage Rent Control Demand 0 9 Quantity supplied Quanti Quantity ty demanded 11
Effect of Rent Control Ren t Rent is not low for everyone Since a rent higher than $400 is illegal, the $500 market cannot work to allocate the housing units among people. Illegal payments to 400 landlords Rent is higher in non rent controlled areas 0 Supply Shortage Rent Control Demand 9 Quantity supplied Quanti Quantity ty demanded 11
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
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?
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, Labo r Total Product 0 0 1 5 2 25 3 50 4 70 5 80 6 85 7 86 Margina l Product MRP
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 MRP 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 5 Labor Demand 2.5 1 5 6 Quantity of
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 eneral Conclusion: Labor supply is upward slop
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.
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, . The price that sellers receive, . The difference between the two is the tax, t. Let’s first consider a tax on sellers.
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 Tax wedge ($0.5) Winners: government revenue Price sellers Receive ($2.8) D 0 Qt The tax results in a reduction in quantity Quantity