Topic 5: Demand, Supply & Government Policies PDF

EC4101 Topic 5: Demand, Supply & Government Policies Minimum pricing Learning objectives The meaning of price controls and quantity controls, two kinds of government interventions in markets Ho...

EC4101 Topic 5: Demand, Supply & Government Policies Minimum pricing Learning objectives The meaning of price controls and quantity controls, two kinds of government interventions in markets How price and quantity controls create problems and can make a market inefficient What deadweight loss is Why the predictable side effects of intervention in markets often lead economists to be sceptical of its usefulness Who benefits and who loses from market interventions, and why they are used despite their well-known problems Why Governments Control Prices The market price moves to the level at which the quantity supplied equals the quantity demanded BUT this equilibrium price does not necessarily please either buyers or sellers Therefore, the government intervenes to regulate prices by imposing price controls, which are legal restrictions on how high or low a market price may go  Interference in Markets Has Consequences Distorted price signals cause resources to be misallocated If prices are distorted, they cannot give good information to buyers and sellers Price controls Price ceiling is the maximum price sellers are allowed to charge for a good or service Must be set BELOW equilibrium price to be binding Price floor is the minimum price buyers are required to pay for a good or service Must be set ABOVE equilibrium price to be binding Price Ceilings Price ceilings are typically imposed during crises (wars, harvest failures, natural disasters) because these events often lead to sudden price increases that hurt many people but produce big gains for a lucky few Examples: U.S. Government imposed ceilings on aluminium and steel prices during World War II Rent control in New York Price Ceilings Two outcomes are possible when the government imposes a price ceiling: The price ceiling is not binding if set above the equilibrium price The price ceiling is binding if set below the equilibrium price, leading to a shortage  The Market for Apartments in the Absence of Government Controls Monthly rent (per apartment) Quantity of apartments S (millions) €1,400 Monthly rent Quantity Quantity (per apartment) 1,300 demanded supplied 1,200 €1,400 1.6 2.4 1,100 1,300 1.7 2.3 E 1,200 1.8 2.2 1,000 1,100 1.9 2.1 900 1,000 2.0 2.0 800 900 2.1 1.9 700 800 2.2 1.8 700 2.3 1.7 600 D 600 2.4 1.6 0 1.6 1.7 1.8 1.9 2.0 2.1 2.2 2.3 2.4 Quantity of apartments (millions)  The Effects of a Price Ceiling Monthly rent (per apartment) S €1,400 1,200 E 1,000 Price A B ceiling 800 Housing shortage of 400,000 apartments 600 caused by price D ceiling 0 1.6 1.8 2.0 2.2 2.4 Quantity of apartments (millions) A Price Ceiling Causes Inefficiently Low Quantity Monthly rent (per apartment) Deadweight loss from fall in number S €1,400 of apartments rented 1,200 E 1,000 Price ceiling 800 600 D 0 1.6 1.8 2.0 2.2 2.4 Quantity of apartments (millions) Quantity Quantity supplied supplied with without rent control rent control How Price Ceilings Cause Inefficiency Inefficiently Low Quantity Deadweight loss is the loss in total surplus that occurs whenever an action or a policy reduces the quantity transacted below the efficient market equilibrium quantity Inefficient Allocation to Customers Wasted Resources Inefficiently Low Quality Black Markets  Winners and Losers from Rent Control Monthly rent (per Monthly rent (b) After Rent Control (a) Before Rent Control apartment) (per apartment) Consumer Consumer S surplus Consumer surplus S surplus transferred from €1,400 €1,400 producers 1,200 1,200 Price E E ceiling 1,000 1,000 800 800 600 600 Producer Producer Deadweight surplus D surplus loss D 0 1.6 1.8 2.0 2.2 2.4 0 1.6 1.8 2.0 2.2 2.4 Quantity of apartments (millions) Quantity of apartments (millions) Economics in action: Rent Control in New York Over 1m apartments in NYC subject to rent regulation (rent stabilisation) that restricts ability of landlords to increase rent Approx. 28% of overall NYC housing stock and 44% of all rentals Economics in action: Shopping in Caracas Supermarket shopping in Caracas, Venezuela, in recent years has been a bizarre experience. Shelves can be fully stocked with luxury food items, but basic staples like milk and sugar are often absent because of price controls Price controls introduced by Venezuelan president in order to protect poor and working classes from high inflation and increasing cost of basic foods such as beans, chicken, sugar, etc. These policies in turn led to massive shortages, higher spending by consumers and sharply rising prices for goods whose prices were not controlled For controlled goods, many argue that prices are set so low, farmers grow less food, manufacturers reduce production and retailers stock less Price controls have a long history! Code of Hammurabi, Babylon, 1772 B.C.: “If a man hire a herdsman, he shall give him six gur of corn per annum” Price of grain fixed by fiat in Egypt in third century B.C. causing many to leave farms and collapse of economy In 284 A.D. Roman emperor Diocletian fixed the maximum prices at which beef, grain, eggs, clothing and other articles could be sold. Those who sold at higher prices faced death penalty Result: “the people brought provisions no more to markets, since they could not get a reasonable price for them and this increased the dearth so much, that at last after many had died by it, the law itself was set aside” (Schuettinger and Butler, 1979) Price Floors Sometimes governments intervene to push market prices up instead of down The minimum wage is a legal floor on the wage rate, which is the market price of labour Just like price ceilings, price floors are intended to help some people but generate predictable and undesirable side effects  The Market for Butter in the Absence of Government Controls Price of butter (per pound) S Quantity of butter €1.40 (millions of pounds) 1.30 Price of butter Quantity Quantity (per pound) demanded supplied 1.20 €1.40 8.0 14.0 1.10 $1.30 8.5 13.0 E 1.00 $1.20 9.0 12.0 $1.10 9.5 11.0 0.90 $1.00 10.0 10.0 0.80 $0.90 10.5 9.0 $0.80 11.0 8.0 0.70 $0.70 11.5 7.0 0.60 $0.60 12.0 6.0 D 0 6 7 8 9 10 11 12 13 14 Quantity of butter (millions of pounds)  The Effects of a Price Floor Price of butter (per pound) S €1.40 Butter surplus of 3 million pounds caused by price floor 1.20 A B Price floor E 1.00 0.80 0.60 D 0 6 8 9 10 12 14 Quantity of butter (millions of pounds) How a Price Floor Causes Inefficiency The persistent surplus that results from a price floor creates missed opportunities (inefficiencies) that resemble those created by the shortage that results from a price ceiling. These include: Deadweight loss from inefficiently low quantity Inefficient allocation of sales among sellers Wasted resources Inefficiently high quality Temptation to break the law by selling below the legal price A Price Floor Causes Inefficiently Low Quantity Price of butter (per pound) S €1.40 1.20 Deadweight loss Price floor E 1.00 0.80 0.60 D 0 6 8 9 10 12 14 Quantity of butter (millions of pounds) Quantity Quantity demanded with demanded price floor without price floor How a Price Floor Causes Inefficiency Price floors lead to inefficient allocation of sales among sellers: those who would be willing to sell the good at the lowest price are not always those who actually manage to sell it Price floors often lead to inefficiency in that goods of inefficiently high quality are offered: sellers offer high-quality goods at a high price, even though buyers would prefer a lower quality at a lower price Minimum Wage An important example of a price floor is the minimum wage. Minimum wage laws dictate the lowest price for labour that any employer may pay How the Minimum Wage Affects the Labour Market Wage labour Supply Equilibrium wage labour demand 0 Equilibrium Quantity of employment labour How the Minimum Wage Affects the Labour Market Wage labour labour surplus Supply (unemployment) Minimum wage labour demand 0 Quantity Quantity Quantity of demanded supplied labour Economics in Action: Illegal Labour in EU Minimum wages in many EU countries have been set much higher than in other countries such as US The persistent surplus that results from this price floor appears in the form of higher unemployment In countries where enforcement of labour law is lax, it can result in widespread evasion of the law In many countries, workers are employed by companies that pay them less than the minimum wage and fail to provide health care and retirement benefits. Many jobs also go unreported Ceilings, Floors and Quantities A price ceiling pushes the price of a good down A price floor pushes the price of a good up Both floors and ceilings reduce the quantity bought and sold If sellers don’t want to sell as much as buyers want to buy, it’s the sellers who determine the actual quantity sold, because buyers can’t force unwilling sellers to sell and vice versa Controlling Quantities A quantity control, or quota, is an upper limit on the quantity of some good that can be bought or sold. The total amount of the good that can be legally transacted is the quota limit. An example is the taxi medallion system in New York A license gives its owner the right to supply a good The demand price of a given quantity is the price at which consumers will demand that quantity The supply price of a given quantity is the price at which producers will supply that quantity. The Market for White Sugar in the Absence of Government Controls Price (per tonne) Quantity of sugar (millions of tonnes per year) S Price €7.00 Quantity Quantity (per tonne) demanded supplied 6.50 €7.00 6 14 6.00 $6.50 7 13 5.50 E $6.00 8 12 5.00 $5.50 9 11 4.50 $5.00 10 10 4.00 $4.50 11 9 3.50 $4.00 12 8 3.00 D $3.50 13 7 $3.00 14 6 0 6 7 8 9 10 11 12 13 14 Quantity of sugar (millions of tonnes per year)  Effect of a Quota on the Market for White Sugar Price (per tonne) Quantity of sugar (millions of tonnes per year) Deadweight S Price Quantity Quantity €7.00 loss (per tonne) demanded supplied 6.50 A €7.00 6 14 6.00 The $6.50 7 13 5.50 E “wedge” $6.00 8 12 5.00 $5.50 9 11 4.50 $5.00 10 10 4.00 B $4.50 11 9 3.50 $4.00 12 8 3.00 D $3.50 13 7 Quota $3.00 14 6 0 6 7 8 9 10 11 12 13 14 Quantity of sugar (millions of tonnes per year) The Anatomy of Quantity Controls A quantity control, or quota, drives a wedge between the demand price and the supply price of a good; that is, the price paid by buyers ends up being higher than the price producers are willing to sell at The difference between the demand and supply price at the quota limit is the quota rent, the earnings that accrue to the license-holder from ownership of the right to sell the good. It is equal to the market price of the license when the licenses are traded The Costs of Quantity Controls Deadweight loss because some mutually beneficial transactions don’t occur Incentives for illegal activities Economics in Action: EU Fishing Quotas EU imposes strict quotas on number of different types of fish that can be caught by each country Any fish caught above quota must be dumped back in the sea Quotas restrict supply and raise prices in short term but protect fish stock from depletion/extinction in long term How Taxes on Sellers Affect Market Outcomes Governments levy taxes to raise revenue for current and capital spending Taxes discourage market activity When a good is taxed, the quantity sold is smaller Buyers and sellers generally share the tax burden Price Elasticity and Tax Incidence Taxes result in a change in market equilibrium. Buyers pay more and sellers receive less, regardless of whom the tax is levied on The tax incidence is the manner in which the burden of a tax is shared among participants in a market We will examine a unit tax on a good – illustrated as a parallel shift of a supply or demand curve by the amount of the tax  Tax of 10 cent per unit is levied on producer Pre-tax 100 units produced SG at price of €1 P 10 cent tax Tax shifts S-curve upwards S0 Shifts from S0 → SG New equilibrium at B 1.10 B Consumers demand 90 and 1.05 pay €1.05 1.00 E Producers receive €0.95 0.95 after tax Producer unable to pass on D full cost of tax because as P↑ the QD↓ 80 90 100 Q  Tax of t per unit is levied – consider this as raising the supply price SG CS was P0 A E P PS was P0 F E S0 A CS now PG A B (blue Δ) PS now PN F D (green Δ) B Tax revenue = PN PG B D PG i.e. pink rectangle P0 E Deadweight loss = D B E PN D i.e. grey triangle Total loss of surplus D = PN PG B E D F Q1 Q0 Q Price Elasticity and Tax Incidence In what proportions is the burden of the tax divided? The answer to this question depends on the price elasticity of demand and the price elasticity of supply  How the Burden of a Tax Is Divided (a) Price Elastic Supply, Price Inelastic Demand Price 1. When supply is more price elastic than demand... Price buyers pay Supply Tax 2.... the incidence of the Price without tax tax falls more heavily on Price sellers consumers... receive 3.... than Demand on producers. 0 Quantity  How the Burden of a Tax Is Divided (b) Price Inelastic Supply, Price Elastic Demand Price 1. When demand is more price elastic than supply... Price buyers pay Supply Price without tax 3.... than on consumers. Tax 2.... the Demand Price sellers incidence of receive the tax falls more heavily on producers... 0 Quantity Price Elasticity and Tax Incidence So, how is the burden of the tax divided? The burden of a tax falls more heavily on the side of the market that is less price elastic i.e. less sensitive to price changes NB: the more inelastic the demand or supply the lower the deadweight loss From efficiency perspective, levy taxes on goods with inelastic supply (e.g. land) or inelastic demand (e.g. necessities) But can’t ignore equity concerns and the ‘politics’ of the above advice Summary 1. Even when a market is efficient, governments often intervene to pursue greater fairness or to please a powerful interest group. Interventions can take the form of price controls or quantity controls, both of which generate predictable and undesirable side effects 2. A price ceiling, a maximum market price below the equilibrium price, benefits successful buyers but creates persistent shortages. Price ceilings lead to inefficiencies in the form of deadweight loss from inefficiently low quantity, inefficient allocation to consumers, wasted resources, and inefficiently low quality. It also encourages illegal activity as people turn to black markets to get the good. Summary 3. A price floor, a minimum market price above the equilibrium price, benefits successful sellers but creates persistent surplus. Price floors lead to inefficiencies in the form of deadweight loss from inefficiently low quantity, inefficient allocation of sales among sellers, wasted resources, and inefficiently high quality. It also encourages illegal activity and black markets. The most well-known kind of price floor is the minimum wage, but price floors are also commonly applied to agricultural products. 4. A quantity control, or quota, limits the quantity of a good that can be bought or sold. The quantity allowed for sale is the quota limit. The government issues licenses to individuals, the right to sell a given quantity of the good. Economists say that a quota drives a wedge between the demand price and the supply price; this wedge is equal to the quota rent. Quantity controls lead to deadweight loss in addition to encouraging illegal activity Summary 5. When the government levies a tax on a good, the equilibrium quantity of the good falls. A tax on a good places a wedge between the price paid by buyers and the price received by sellers. 6. The incidence of a tax refers to who bears the burden of a tax. The incidence of the tax depends on the price elasticities of supply and demand. The burden tends to fall on the side of the market that is less price elastic