Mankiw, Chapter 6 - Supply, Demand, and Government Policies PDF

Chapter E...

Chapter E 6 conomists have two roles. As scientists, they develop and test theories to explain the world around them. As policy advisers, they use these theories to help change the world for the better. The focus of the preceding two chapters has been scientific. We have seen how supply and demand determine the price of a good and the quantity of the good sold. We have also seen how various events shift supply and demand, thereby changing the equilibrium price and quantity. And we have developed the concept of elasticity to gauge the size of these changes. Supply, Demand, and This chapter offers our first look at policy. Here we analyze vari- ous types of government policy using only the tools of supply and demand. As you will see, the analysis yields some surprising insights. Government Policies often have effects that their architects did not intend or anticipate. We begin by considering policies that control prices. For example, rent-control laws set a maximum rent that landlords may charge tenants. Minimum-wage laws set the lowest wage that firms may pay workers. Price controls are often enacted when policymakers Policies believe that the market price of a good or service is unfair to buyers or sellers. Yet, as we will see, these policies can generate inequities of their own. iStock.com/lolostock 109 Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 38314_ch06_hr_109-130.indd 109has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Editorial review 23/09/19 10:12 am  110 part II How Markets Work After discussing price controls, we consider the impact of taxes. Policymakers use taxes to raise revenue for public purposes and to influence market outcomes. Although the prevalence of taxes in our economy is obvious, their effects are not. For example, when the government levies a tax on the amount that firms pay their workers, do the firms or workers bear the burden of the tax? The answer is not clear—until we apply the powerful tools of supply and demand. 6-1 Controls on Prices To see how price controls affect market outcomes, let’s look once again at the mar- ket for ice cream. As we saw in Chapter 4, if ice cream is sold in a competitive mar- ket free of government regulation, the price of ice cream adjusts to balance supply and demand: At the equilibrium price, the quantity of ice cream that buyers want to buy exactly equals the quantity that sellers want to sell. To be concrete, let’s sup- pose that the equilibrium price is $3 per cone. Some people may not like the outcome of this free-market process. The American Association of Ice-Cream Eaters complains that the $3 price is too high for everyone to enjoy a cone a day (their recommended daily allowance). Meanwhile, the National Organization of Ice-Cream Makers complains that the $3 price—the result of “cutthroat competition”—is too low and is depressing the incomes of its ­members. Each of these groups lobbies the government to pass laws that alter the market outcome by directly controlling the price of an ­ice-cream cone. Because buyers of any good always want a lower price while sellers want a higher price, the interests of the two groups conflict. If the Ice-Cream Eaters are successful in their lobbying, the government imposes a legal maximum on the price at which ice-cream cones can be sold. Because the price is not allowed to price ceiling rise above this level, the legislated maximum is called a price ceiling. By con- a legal maximum on the trast, if the Ice-Cream Makers are successful, the government imposes a legal price at which a good can minimum on the price. Because the price cannot fall below this level, the legis- be sold lated minimum is called a price floor. Let us consider the effects of these policies in turn. price floor a legal minimum on the price at which a good can 6-1a How Price Ceilings Affect Market Outcomes be sold When the government, moved by the complaints and campaign contributions of the Ice-Cream Eaters, imposes a price ceiling in the market for ice cream, two out- comes are possible. In panel (a) of Figure 1, the government imposes a price ceiling of $4 per cone. In this case, because the price that balances supply and demand ($3) is below the ceiling, the price ceiling is not binding. Market forces move the economy to the equilibrium, and the price ceiling has no effect on the price or the quantity sold. Panel (b) of Figure 1 shows the other, more interesting, possibility. In this case, the government imposes a price ceiling of $2 per cone. Because the equilibrium price of $3 is above the price ceiling, the ceiling is a binding constraint on the market. The forces of supply and demand tend to move the price toward the equilibrium price, but when the market price hits the ceiling, it cannot, by law, rise any further. Thus, the market price equals the price ceiling. At this price, the quantity of ice cream demanded (125 cones in the figure) exceeds the quantity supplied (75 cones). Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 38314_ch06_hr_109-130.indd 110has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Editorial review 23/09/19 10:12 am  CHAPTER 6 Supply, Demand, and Government Policies 111 In panel (a), the government imposes a price ceiling of $4. Because the price ceiling is Figure 1 above the equilibrium price of $3, it has no effect, and the market can reach the equilibrium of supply and demand. In this equilibrium, quantity supplied and quantity demanded both A Market with a Price Ceiling equal 100 cones. In panel (b), the government imposes a price ceiling of $2. Because the price ceiling is below the equilibrium price of $3, the market price equals $2. At this price, 125 cones are demanded and only 75 are supplied, so there is a shortage of 50 cones. (a) A Price Ceiling That Is Not Binding (b) A Price Ceiling That Is Binding Price of Price of Ice-Cream Ice-Cream Cone Cone Supply Supply Equilibrium $4 Price price ceiling 3 $3 Equilibrium price 2 Price Shortage ceiling Demand Demand 0 100 Quantity of 0 75 125 Quantity of Equilibrium Ice-Cream Quantity Quantity Ice-Cream quantity Cones supplied demanded Cones Because of this excess demand of 50 cones, some people who want to buy ice cream at the going price are unable to do so. In other words, there is a shortage of ice cream. In response to this shortage, some mechanism for rationing ice cream will natu- rally develop. The mechanism could be long lines: Buyers who are willing to arrive early and wait in line get a cone, while those unwilling to wait do not. Alternatively, sellers could ration ice-cream cones according to their own personal biases, selling them only to friends, relatives, or members of their own racial or ethnic group. Notice that even though the price ceiling was motivated by a desire to help buyers of ice cream, not all buyers benefit from the policy. Some buyers pay a lower price, although they may have to wait in line to do so, but other buyers cannot get any ice cream at all. This example in the market for ice cream shows a general result: When the govern- ment imposes a binding price ceiling on a competitive market, a shortage of the good arises, and sellers must ration the scarce goods among the large number of potential buyers. The rationing mechanisms that develop under price ceilings are rarely desirable. Long lines are inefficient because they waste buyers’ time. Discrimination according to seller bias is both inefficient (because the good may not go to the buyer who values it most) and often unfair. By contrast, the rationing mechanism in a free, competi- tive market is both efficient and impersonal. When the market for ice cream reaches its equilibrium, anyone who wants to pay the market price can get a cone. Free markets ration goods with prices. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 38314_ch06_hr_109-130.indd 111has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Editorial review 23/09/19 10:12 am  112 part II How Markets Work Lines at the Gas Pump Case As we discussed in Chapter 5, in 1973 the Organization of Petroleum Study Exporting Countries (OPEC) reduced production of crude oil, thereby increasing its price in world oil markets. Because crude oil is used to make gasoline, the higher oil prices reduced the supply of gasoline. Long lines at gas stations became common, with motorists often waiting for hours to buy a few gallons of gas. What was responsible for the long gas lines? Most people blame OPEC. Surely, if OPEC had not reduced production of crude oil, the shortage of gasoline would not have occurred. Yet economists blame the U.S. government regulations that limited the price oil companies could charge for gasoline. Figure 2 reveals what happened. As panel (a) shows, before OPEC raised the price of crude oil, the equilibrium price of gasoline, P1 , was below the price ceil- ing. The price regulation, therefore, had no effect. When the price of crude oil rose, however, the situation changed. The increase in the price of crude oil raised the cost of producing gasoline and thereby reduced the supply of gasoline. As panel (b) shows, the supply curve shifted to the left from S1 to S2. In an unregulated mar- ket, this shift in supply would have raised the equilibrium price of gasoline from P1 to P2 , and no shortage would have occurred. Instead, the price ceiling prevented the price from rising to the equilibrium level. At the price ceiling, producers were willing to sell QS, but consumers were willing to buy QD. Thus, the shift in supply caused a severe shortage at the regulated price. Figure 2 Panel (a) shows the gasoline market when the price ceiling is not binding because the equilibrium price, P1, is below the ceiling. Panel (b) shows the gasoline market after an The Market for Gasoline increase in the price of crude oil (an input into making gasoline) shifts the supply curve to with a Price Ceiling the left from S1 to S2. In an unregulated market, the price would have risen from P1 to P2. The price ceiling, however, prevents this from happening. At the binding price ceiling, consumers are willing to buy QD , but producers of gasoline are willing to sell only QS. The difference between quantity demanded and quantity supplied, QD 2 QS , measures the gasoline shortage. (a) The Price Ceiling on Gasoline Is Not Binding (b) The Price Ceiling on Gasoline Is Binding Price of Price of S2 Gasoline Gasoline 2.... but when supply falls... Supply, S1 S1 1. Initially, P2 the price ceiling is not binding... Price ceiling Price ceiling P1 P1 3.... the price 4.... ceiling becomes resulting binding... in a Demand shortage. Demand 0 Q1 Quantity of 0 QS QD Q1 Quantity of Gasoline Gasoline Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 38314_ch06_hr_109-130.indd 112has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Editorial review 23/09/19 10:12 am  CHAPTER 6 Supply, Demand, and Government Policies 113 Eventually, the laws regulating the price of gasoline were repealed. Lawmakers came to understand that they were partly responsible for the many hours Americans lost waiting in line to buy gasoline. Today, when the price of crude oil changes, the price of gasoline can adjust to bring supply and demand into equilibrium. Rent Control in the Short Run Case and the Long Run Study One common example of a price ceiling is rent control. In many ­cities, the local government places a ceiling on rents that landlords may charge their tenants. The goal of this policy is to help the poor by making housing more affordable. Economists often criticize rent control, arguing that it is a highly inefficient way to help the poor raise their standard of living. One economist called rent control “the best way to destroy a city, other than bombing.” The adverse effects of rent control are less apparent to the general population because these effects occur over many years. In the short run, landlords have a fixed number of apartments to rent, and they cannot adjust this number quickly as market conditions change. Moreover, the number of people searching for housing in a city may not be highly responsive to rents in the short run because people take time to adjust their housing arrangements. Therefore, the short-run supply and demand for housing are both relatively inelastic. Panel (a) of Figure 3 shows the short-run effects of rent control on the ­housing market. As with any binding price ceiling, rent control causes a shortage. But Panel (a) shows the short-run effects of rent control: Because the supply and demand Figure 3 curves for apartments are relatively inelastic, the price ceiling imposed by a rent-control law causes only a small shortage of housing. Panel (b) shows the long-run effects of rent control: Rent Control in the Short Because the supply and demand curves for apartments are more elastic, rent control causes a Run and in the Long Run larger shortage. (a) Rent Control in the Short Run (b) Rent Control in the Long Run (supply and demand are inelastic) (supply and demand are elastic) Rental Rental Price of Price of Apartment Supply Apartment Supply Controlled rent Controlled rent Shortage Demand Shortage Demand 0 Quantity of 0 Quantity of Apartments Apartments Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 38314_ch06_hr_109-130.indd 113has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Editorial review 23/09/19 10:12 am  114 part II How Markets Work because supply and demand are inelastic in the short run, the initial shortage caused by rent control is small. The primary result in the short run is a reduction in rents. The long-run story is very different because the buyers and sellers of rental housing respond more to market conditions as time passes. On the supply side, landlords respond to low rents by not building new apartments and by failing to maintain existing ones. On the demand side, low rents encourage people to find their own apartments (rather than living with roommates or their parents) and induce more people to move into the city. Therefore, both supply and demand are more elastic in the long run. Panel (b) of Figure 3 illustrates the housing market in the long run. When rent control depresses rents below the equilibrium level, the quantity of apartments supplied falls substantially and the quantity of apartments demanded rises sub- stantially. The result is a large shortage of housing. In cities with rent control, landlords use various mechanisms to ration housing. Some landlords keep long waiting lists. Others give preference to tenants without children. Still others discriminate on the basis of race. Sometimes apartments are allocated to those willing to offer under-the-table payments to building superin- tendents. In essence, these bribes bring the total price of an apartment closer to the equilibrium price. To fully understand the effects of rent control, recall one of the Ten Principles of Economics from Chapter 1: People respond to incentives. In free markets, land- lords try to keep their buildings clean and safe because desirable apartments command higher prices. But when rent control creates shortages and waiting lists, landlords lose their incentive to respond to tenants’ concerns. Why should a landlord spend money to maintain and improve the property when people are waiting to move in as it is? In the end, tenants get lower rents, but they also get lower-quality housing. Policymakers often react to the adverse effects of rent con- trol by imposing additional regulations. For example, various laws make racial discrimination in housing illegal and require Rent Control landlords to provide minimally adequate living conditions. These laws, however, are difficult and costly to enforce. By contrast, without rent control, such laws are less necessary because the market for housing is regulated by the forces of “Local ordinances that limit rent increases for some rental competition. In a free market, the price of housing adjusts to housing units, such as in New York and San Francisco, have eliminate the shortages that give rise to undesirable landlord had a positive impact over the past three decades on the behavior. amount and quality of broadly affordable rental housing in cities that have used them.” 6-1b How Price Floors Affect Market Outcomes What do economists say? To examine the effects of another kind of government price 4% uncertain 1% agree control, let’s return to the market for ice cream. Imagine now that the National Organization of Ice-Cream Makers persuades the government that the $3 equilibrium price is too low. In this 95% disagree case, the government might institute a price floor. Price floors, like price ceilings, are an attempt by the government to main- tain prices at other than equilibrium levels. Whereas a price Source: IGM Economic Experts Panel, February 7, 2012. ceiling places a legal maximum on prices, a price floor places a legal minimum. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 38314_ch06_hr_109-130.indd 114has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Editorial review 23/09/19 10:12 am  CHAPTER 6 Supply, Demand, and Government Policies 115 When the government imposes a price floor on the ice-cream market, two out- comes are possible. If the government imposes a price floor of $2 per cone when the equilibrium price is $3, we obtain the outcome in panel (a) of Figure 4. In this case, because the equilibrium price is above the floor, the price floor is not bind- ing. Market forces move the economy to the equilibrium, and the price floor has no effect. Panel (b) of Figure 4 shows what happens when the government imposes a price floor of $4 per cone. In this case, because the equilibrium price of $3 is below the floor, the price floor is a binding constraint on the market. The forces of supply and demand tend to move the price toward the equilibrium price, but when the market price hits the floor, it can fall no further. The market price equals the price floor. At this floor, the quantity of ice cream supplied (120 cones) exceeds the quantity demanded (80 cones). Because of this excess supply of 40 cones, some people who want to sell ice cream at the going price are unable to do so. Thus, a binding price floor causes a surplus. Just as the shortages resulting from price ceilings can lead to undesirable ration- ing mechanisms, so can the surpluses resulting from price floors. The sellers who appeal to the personal biases of the buyers, perhaps due to racial or familial ties, may be better able to sell their goods than those who do not. By contrast, in a free market, the price serves as the rationing mechanism, and sellers can sell all they want at the equilibrium price. In panel (a), the government imposes a price floor of $2. Because the price floor is below Figure 4 the equilibrium price of $3, it has no effect. The market price adjusts to balance supply and demand. At the equilibrium, quantity supplied and quantity demanded both equal A Market with a Price Floor 100 cones. In panel (b), the government imposes a price floor of $4, which is above the equilibrium price of $3. Therefore, the market price equals $4. Because 120 cones are supplied at this price and only 80 are demanded, there is a surplus of 40 cones. (a) A Price Floor That Is Not Binding (b) A Price Floor That Is Binding Price of Price of Ice-Cream Ice-Cream Cone Supply Cone Supply Surplus Equilibrium price $4 Price floor $3 3 Price floor 2 Equilibrium price Demand Demand 0 100 Quantity of 0 80 120 Quantity of Equilibrium Ice-Cream Quantity Quantity Ice-Cream quantity Cones demanded supplied Cones Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 38314_ch06_hr_109-130.indd 115has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Editorial review 23/09/19 10:12 am  116 part II How Markets Work The Minimum Wage Case An important example of a price floor is the minimum wage. Study Minimum-wage laws dictate the lowest price for labor that any employer may pay. The U.S. Congress first instituted a minimum wage with the Fair Labor Standards Act of 1938 to ensure workers a minimally adequate standard of living. In 2018, the minimum wage according to federal law was $7.25 per hour. In addition, many states and cities mandate minimum wages above the federal level. The minimum wage in Seattle, for instance, was $15 per hour in 2018. Most European nations also have laws that establish a minimum wage, often much higher than in the United States. For example, even though the average income in France is almost 30 percent lower than it is in the United States, the French minimum wage is more than 30 percent higher. To examine the effects of a minimum wage, we must consider the market for labor. Panel (a) of Figure 5 shows the labor market, which, like all markets, is sub- ject to the forces of supply and demand. Workers supply labor, and firms demand labor. If the government doesn’t intervene, the wage adjusts to balance labor sup- ply and labor demand. Panel (b) of Figure 5 shows the labor market with a minimum wage. If the minimum wage is above the equilibrium level, as it is here, the quantity of labor supplied exceeds the quantity demanded. The result is a surplus of labor, or unem- ployment. While the minimum wage raises the incomes of those workers who have jobs, it lowers the incomes of would-be workers who now cannot find jobs. To fully understand the minimum wage, keep in mind that the economy con- tains not a single labor market but many labor markets for different types of work- ers. The impact of the minimum wage depends on the skill and experience of the worker. Highly skilled and experienced workers are not affected because their equilibrium wages are well above the minimum. For these workers, the minimum wage is not binding. Figure 5 Panel (a) shows a labor market in which the wage adjusts to balance labor supply and labor demand. Panel (b) shows the impact of a binding minimum wage. Because the minimum How the Minimum Wage wage is a price floor, it causes a surplus: The quantity of labor supplied exceeds the Affects the Labor Market quantity demanded. The result is unemployment. (a) A Free Labor Market (b) A Labor Market with a Binding Minimum Wage Wage Wage Labor Labor supply supply Labor surplus (unemployment) Minimum wage Equilibrium wage Labor Labor demand demand 0 Equilibrium Quantity of 0 Quantity Quantity Quantity of employment Labor demanded supplied Labor Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 38314_ch06_hr_109-130.indd 116has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Editorial review 23/09/19 10:12 am  CHAPTER 6 Supply, Demand, and Government Policies 117 The minimum wage has its greatest impact on the market for teenage labor. The equilibrium wages of teenagers are low because teenagers are among the least skilled and least experienced members of the labor force. In addition, teenagers are often willing to accept a lower wage in exchange for on-the-job training. (Some teenagers, including many college students, are willing to work as interns for no pay at all. Because internships pay nothing, minimum-wage laws often do not apply to them. If they did, these internship opportunities might not exist.) As a result, the minimum wage is binding more often for teenagers than for other mem- bers of the labor force. Many economists have studied how minimum-wage laws affect the teenage labor market. These researchers compare the changes in the minimum wage over time with the changes in teenage employment. Although there is some debate about the effects of minimum wages, the typical study finds that a 10 percent increase in the minimum wage depresses teenage employment by 1 to 3 percent. One drawback of most minimum-wage studies is that they focus on the effects over short periods of time. For example, they might compare employment the year before and the year after a change in the minimum wage. The longer-term effects on employment are harder to reliably estimate, but they are more relevant for evalu- ating the policy. Because it takes time for firms to reorganize the workplace, the long-run decline in employment from a higher minimum wage is likely larger than the estimated short-run decline. In addition to altering the quantity of labor demanded, the minimum wage alters the quantity supplied. Because the minimum wage raises the wage that teenagers can earn, it increases the number of teenagers who choose to look for jobs. Studies have found that a higher minimum wage also influences which teenagers are employed. When the minimum wage rises, some teenagers who are still attending high school choose to drop out and take jobs. With more people vying for the avail- able jobs, some of these new dropouts displace other teenagers who had already dropped out of school, and these displaced teenagers now become unemployed. The minimum wage is a frequent topic of debate. Advocates of the minimum wage view the policy as one way to raise the income of the working poor. They cor- rectly point out that workers who earn the minimum wage can afford only a meager standard of living. In 2018, for instance, when the minimum wage was $7.25 per hour, two adults work- ing 40 hours a week for every week of the year at minimum- The Minimum wage jobs had a joint annual income of only $30,160. This Wage amount was only about 40 percent of the median family income in the United States. Many proponents of the minimum wage admit that it has some adverse effects, including unemployment, “If the federal minimum wage is raised gradually to $15-per- but they believe that these effects are small and that, all things hour by 2020, the employment rate for low-wage U.S. workers considered, a higher minimum wage makes the poor better off. will be substantially lower than it would be under the status Opponents of the minimum wage contend that it is not quo.” the best way to combat poverty. They note that a high mini- What do economists say? mum wage causes unemployment, encourages teenagers to drop out of school, and prevents some unskilled workers from 29% disagree 37% uncertain getting on-the-job training. Moreover, opponents of the mini- mum wage point out that it is a poorly targeted policy. Not all minimum-wage workers are heads of households trying to 34% agree help their families escape poverty. In fact, less than a third of minimum-wage earners are in families with incomes below the poverty line. Many are teenagers from middle-class homes Source: IGM Economic Experts Panel, September 22, 2015. working at part-time jobs for extra spending money. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 38314_ch06_hr_109-130.indd 117has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Editorial review 23/09/19 10:12 am  118 part II How Markets Work 6-1c Evaluating Price Controls One of the Ten Principles of Economics in Chapter 1 is that markets are usually a good way to organize economic activity. This principle explains why economists often oppose price ceilings and price floors. To economists, prices are not the outcome of some haphazard process. Prices, they contend, are the result of the millions of busi- ness and consumer decisions that lie behind the supply and demand curves. Prices have the crucial job of balancing supply and demand and, thereby, coordinating economic activity. When policymakers set prices by legal decree, they obscure the signals that normally guide the allocation of society’s resources. Another one of the Ten Principles of Economics is that governments can sometimes improve market outcomes. Indeed, policymakers are motivated to control prices because they view the market’s outcome as unfair. Price controls are often aimed at helping the poor. For instance, rent-control laws try to make housing affordable for everyone, and minimum-wage laws try to help people escape poverty. Yet when policymakers impose price controls, they can hurt some people they are trying to help. Rent control keeps rents low, but it also discourages landlords from maintaining their buildings and makes housing hard to find. Minimum- wage laws raise the incomes of some workers, but they also cause other workers to become unemployed. Helping those in need can be accomplished in ways other than controlling prices. For instance, the government can make housing more affordable by paying a fraction of the rent for poor families. Unlike rent control, such rent subsidies do not reduce the quantity of housing supplied and, therefore, do not lead to housing shortages. Similarly, wage subsidies raise the living standards of the working poor without discouraging firms from hiring them. An example of a wage subsidy is the earned income tax credit, a government program that supplements the incomes of low-wage workers. Although these alternative policies are often better than price controls, they are not perfect. Rent and wage subsidies cost the government money and, therefore, require higher taxes. As we see in the next section, taxation has costs of its own. QuickQuiz 1. When the government imposes a binding price floor, 3. Rent control causes larger shortages in the it causes _________ run because over that time horizon, a. the supply curve to shift to the left. supply and demand are _________ elastic. b. the demand curve to shift to the right. a. long; more c. a shortage of the good to develop. b. long; less d. a surplus of the good to develop. c. short; more 2. In a market with a binding price ceiling, increasing d. short; less the ceiling price will 4. An increase in the minimum wage reduces the total a. increase the surplus. amount paid to the affected workers if the price b. increase the shortage. elasticity of _________ is _________ than one. c. decrease the surplus. a. supply; greater d. decrease the shortage. b. supply; less c. demand; greater d. demand; less Answers at end of chapter. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 38314_ch06_hr_109-130.indd 118has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Editorial review 23/09/19 10:12 am  CHAPTER 6 Supply, Demand, and Government Policies 119 6-2 Taxes All governments—from national governments around the world to local govern- ments in small towns—use taxes to raise revenue for public projects, such as roads, schools, and national defense. Because taxes are such an important policy instru- ment and affect our lives in many ways, we return to the study of taxes several times throughout this book. In this section, we begin our study of how taxes affect the economy. To set the stage for our analysis, imagine that a local government decides to hold an annual ice-cream celebration—with a parade, fireworks, and speeches by town officials. To raise revenue to pay for the event, the town decides to place a $0.50 tax on each sale of ice-cream cones. When the plan is announced, our two lobbying groups swing into action. The American Association of Ice-Cream Eaters claims that consumers of ice cream are having trouble making ends meet, and it argues that sellers of ice cream should pay the tax. The National Organization of Ice-Cream Makers claims that its members are struggling to survive in a competitive market, and it argues that buyers of ice cream should pay the tax. The town mayor, hoping for a compromise, suggests that half the tax be paid by the buyers and half be paid by the sellers. To analyze these proposals, we need to address a simple but subtle question: When the government levies a tax on a good, who actually bears the burden of the tax? The people buying the good? The people selling the good? Or if buyers and sellers share the tax burden, what determines how the burden is divided? Can the government legislate the division of the burden, as the mayor is suggesting, or is the division determined by market forces? The term tax incidence refers to how the tax incidence burden of a tax is distributed among the various people who make up the economy. the manner in which the As we will see, some surprising lessons about tax incidence can be learned by burden of a tax is shared applying the tools of supply and demand. among participants in a market 6-2a How Taxes on Sellers Affect Market Outcomes We begin by considering a tax levied on sellers of a good. Suppose the local ­government passes a law requiring sellers of ice-cream cones to send $0.50 to the government for every cone they sell. How does this law affect the buyers and sellers of ice cream? To answer this question, we can follow the three steps in Chapter 4 for analyzing supply and demand: (1) We decide whether the law affects the sup- ply curve or the demand curve. (2) We decide which way the curve shifts. (3) We examine how the shift affects the equilibrium price and quantity. Step One   The immediate impact of the tax is on the sellers of ice cream. Because the tax is not levied on buyers, the quantity of ice cream demanded at any given price remains the same; thus, the demand curve does not change. By contrast, the tax on sellers makes the ice-cream business less profitable at any given price, so it shifts the supply curve. Step Two   Because the tax on sellers raises the cost of producing and selling ice cream, it reduces the quantity supplied at every price. The supply curve shifts to the left (or, equivalently, upward). In addition to determining the direction in which the supply curve moves, we can also be precise about the size of the shift. For any market price of ice cream, the effective price to sellers—the amount they get to keep after paying the tax—is $0.50 lower. For example, if the market price of a cone happened to be $2.00, the effective Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 38314_ch06_hr_109-130.indd 119has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Editorial review 23/09/19 10:12 am  120 part II How Markets Work Should the Minimum Wage Be $15 an Hour? There are several reasons why workers’ Certainly not every one of the hundreds of wages are currently too low to provide what studies on the topic confirms this conclu- In 2016 California legislators passed many view as an acceptable standard of living. sion. But there are also studies claiming a law increasing the state minimum One big factor is that technological changes that humans have not contributed to climate wage to $15 an hour by 2022. An have increased the value of higher-skilled work change, and that supply-side economics did economist who studies the issue says and reduced the value of lower-skilled work. not contribute to massive budget deficits. there are better ways to help the Globalization, meanwhile, has brought many The most comprehensive survey of minimum working poor. lower-skilled American workers into greater wage studies, which I conducted with William competition with their counterparts in other Wascher of the Federal Reserve System, found Why market forces will over- countries. that two-thirds of studies point to negative whelm a higher minimum wage Simply requiring employers to pay $15 employment effects, as do over 80% of the won’t provide much ballast against these mar- more credible studies. By David Neumark ket forces. In fact, data indicate that minimum Yet another reason to be wary of raising the T he slogans are everywhere: Fight for 15; wages are ineffective at delivering benefits to minimum wage is that modest job loss over- People Not Profits; One Job Should Be poor or low-income families, and that many all may mask much steeper job loss among Enough. Worsening income inequality and the of the benefits flow to higher-income families. the least skilled. Economists use the phrase persistence of poverty have spurred a move- That’s because minimum wages target low “labor-labor substitution” to describe employ- ment to raise the minimum wage, at both the wages rather than low family incomes. And ers responding to a higher minimum wage by national and state levels. Some West Coast many minimum-wage workers are not poor or replacing their lowest-skilled workers with cities have already voted to boost their mini- even in low-income families; nearly a quarter higher-skilled workers, whom they are more mum wage to $15, or more than double the are teenagers who will eventually find better- willing to hire at the higher minimum. federal standard. And Los Angeles is now con- paid jobs. Moreover, most poor families have Based on my research, I think it is likely sidering a similarly aggressive move. no workers at all. that a $15 minimum wage in Los Angeles will The labor market problems that these higher As a result, for every $5 in higher wages lead some teenagers currently focused on their minimum wages are intended to fix are very that a higher minimum imposes on employers, education to take part-time jobs at the new, real. But would a higher wage floor address the only about $1 goes to poor families, whereas higher minimum, and displace low-skilled underlying problems? A large body of research roughly twice as much goes to families with workers from the jobs they now hold. That shows that the answer is almost certainly no, incomes above the median. seems like a bad outcome. and that there are better solutions, although Higher minimum wages also reduce If we really want to help low-skilled work- they are harder for policymakers to embrace. employment for the least-skilled workers. ers, we need to recognize that the solutions price received by sellers would be $1.50. Whatever the market price, sellers will supply a quantity of ice cream as if the price were $0.50 lower than it is. Put differ- ently, to induce sellers to supply any given quantity, the market price must now be $0.50 higher to compensate for the effect of the tax. Thus, as shown in Figure 6, the supply curve shifts upward from S1 to S2 by the exact size of the tax ($0.50). Step Three   Having determined how the supply curve shifts, we can now com- pare the initial and the new equilibria. Figure 6 shows that the equilibrium price of ice cream rises from $3.00 to $3.30, and the equilibrium quantity falls from 100 to 90 cones. Because sellers sell less and buyers buy less in the new equilibrium, the tax reduces the size of the ice-cream market. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 38314_ch06_hr_109-130.indd 120has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Editorial review 23/09/19 10:12 am  CHAPTER 6 Supply, Demand, and Government Policies 121 that actually work are expensive, difficult to economy, which achieve or both. has permitted Guaranteeing a minimally acceptable those at the top standard of living for those who work entails to earn dramati- redistribution of some kind. Minimum wage is cally increasing one form of redistribution—although we don’t salaries while always think of it as such—but it’s a blunt incomes at the instrument. Using the tax system is clearly bottom have better. stagnated.