Assignment for Next Lecture

• Do Homework 4 on ‘Homework Assignment’ by next Monday Noon

• Read Chapter 5

• Topics Next Time– Concept of Elasticity (degree of price responsiveness)

Market Strikes Back

Lecture 6

In This Lecture

• Market Interventions– Price Floors– Price Ceilings– Taxes or Subsidies– Quotas

• Examples– Minimum Wages and Wage Subsidies– Rent Control– Trade Policy (Quota and Tariffs)

Market Interventions

Even in a society where individuals are free to make voluntary exchanges, a society may decide to intervene in the market through its government. We will discuss the reasons in a later lecture, but for the time being let us assume that the government wants to favor one side of the trades over the other.

– Suppliers want high prices. – Buyers of a good want low prices.

Consider two examples that highlight how governments may intervene.

Market Interventions, cont.

• To favor the suppliers of a good, the government could adopt– price floors (the minimum price that can be paid to a supplier for a

good or service) • Example: a minimum wage

– or subsidies -- supplements to the market price paid to the supplier• Example: a wage subsidy such as the Earned Income Tax Credit

(EITC)

• To favor the demanders of a good, the government could adopt:– price ceilings (a maximum price that can be charged)

• Example: rent control

– subsidies --a supplement to demanders’ incomes• Example: rent subsidies

A Word of Caution

In a later lectures we will argue that a perfectly competitive market will create the greatest amount of combined surplus for consumers and firms. However, we will also suggest that markets can under certain situations fail and consequently the market outcomes can be improved through government intervention (recall Lecture 2). Also the government could justify intervention to pursue non efficiency related goals -- equity or fairness -- often at the expense of efficiency.

Sometimes the sacrifice of efficiency is not justified by the gains in another goal. Justifying this loss in efficiency is not the focus of today’s lecture, however; rather our focus is the potential impacts of government intervention on prices and quantities -- positive analysis.

Opinion Survey

Do you favor raising the federal minimum wage from its current level of $5.15 to $7.15 per hour?

a. Yesb. No

Basic facts (beliefs?) about the minimum wage

• A minimum wage increase would raise the wages of millions of workers.

• Minimum wage increases benefit working families.

• Minimum wage increases benefit disadvantaged workers.

• Source: http://www.epinet.org/content.cfm/issueguides_minwage_minwagefacts

Why many economists oppose the minimum wage

• The displacement effects of increasing the minimum wage outweigh the increased incomes to the workers who retain their jobs.

• Most minimum wage earners are not poor.– Average family income of a minimum wage employee is

$44,331. – Only one in five minimum wage workers lives in a poor family. – Most people don’t get stuck at the minimum wage.– Only 15% of minimum wage earners are single parents or

single earners in a family with kids.

• The minimum wage is a blunt instrument for trying to raise the incomes of the poor.

Price Floors: The Minimum Wage

and the Low Skill Labor Market

• In the absence of any intervention, low skill workers earn Wo and L0 are employed.

• Government institutes a Minimum Wage equal to MW (to be effective it must be above the equilibrium wage)

• Workers earn MW but only L1 are employed and LS want to work at this wage

• Unemployment is U = LS - L1

• Individuals who do find work are better off but Lo-L1 loss their jobs and can’t find work and LS-L0 are enticed into labor market and can’t find jobs

D

Wage

Labor

S

Lo

Wo

L1 LS

MW

U

Wage Subsidies and the Low Skill Labor Market

• Assume the worker is paid a per hourly subsidy of WS. Workers should be willing to supply the same amount of labor if employers paid them Wo- WS (they would take home the same amount of money per hour).

• The Labor Supply Curve relevant to the employers shifts downward by WS. (The analysis is the reverse of that for taxes. Note that the supply price for labor at Lo falls.

• Market wage paid by employers falls to WE

• Employers hire more workers -- total employment rises to L1

• Workers take home per hour MW=WS+WE

• Total amount of subsidy paid by taxpayers

D

Wage

Labor

S

Lo

Wo

L1

MW

S’

WE WS

Clinton Persuaded

New York Times, April 27, 1993

President Clinton has vowed to eliminate poverty among families with a full-time worker. To back that pledge, he proposed a $27 billion increase over five years in the earned income tax credit -- which lowers taxes for low-paid workers or pays them cash if they are too poor to pay taxes. The credit insulates the poor from Social Security payroll taxes and, looking ahead, higher energy taxes. It thus acts to untax the poor who work.

Clinton, the Politician

• Clinton also pushed legislation through Congress that raised the minimum wage from $4.25 in 1992 to $5.15 in 1997.

Value of Minimum Wage, 1954-2004[in 2001 dollars]

Price Ceilings:High Price Rental Markets

• Initially there are Ho housing units that rent for Ro

• Government sets a price ceiling--the highest price that supplies can require of demanders--MR < Ro

• The number of housing units offered for rent falls to H1

• The amount of housing demanded rises to to HD

• Leaving a shortage in the rental market of HS = HD - H1

• Would a subsidy paid to renters be preferable to rent control?

Rental Housing

Rents

Ro

Ho

S

D

MR

HS

H1 HD

Housing Subsidy Paid to Renters

• For Landlords to be willing to supply HD rental properties, the rent (supply price) would have to rise to RS.

• Renters are only will to pay MR for HD housing, but if they are given a subsidy equal to A dollars per unit of housing, their demand for housing would increase.

• A new equilibrium would be established with the equilibrium quantity at HD and the equilibrium price of RS. The cost to renters is RS - A = MR.

• Unfortunately the cost to taxpayers is A dollars times the number of units HD.

• What problems created by rent controls are solved by subsidies?

Rental Housing

Rents

Ro

Ho

S

D

MR

HD

RS

A

D’

Real Gasoline Prices

American Car

Japanese Car

Japanese Car Market• As the price of gas rose, demand for

Japanese cars rose and demand for American cars fell

• American Car makers lost market share and approach Reagan Administration for relief -- they wanted the government to increase the price of Japanese cars to make their cars more attractive to American car buyers.

• Options– Price Floor on Japanese Cars– Tariffs (tax) on Japanese Cars– Quota on Japanese Imports

Price

Japanese Cars

S

D

D’

Qo

Po

Q1

P1

P*

Tariff Option

• Tariff -- a tax on an import that the importer (Japanese Car marker) has to pay. Levied on each car. Tariffs increase the cost of doing business.

• A tariff of amount T per car would raise the cost of a Japanese car by $T -- the supply curve would shift upward by $T.

• The tariff of amount T would rise the price to the consumer to P*. At this price, consumers would demand the number of Japanese cars they did before the rise in the gas prices.

Price

Japanese Cars

S

D

D’

S’

T

P*

Qo

Quota Option

• A quota limits the quantity of a good that can be sold. In our situation, the government would limit the number of Japanese cars to Qo.

• The Supply of Japanese cars would now be equal to S’.

• The price of Japanese cars would rise to P*.

Price

Japanese Cars

S

D

D’

P*

Qo

S’

P1

P0

Which Option -- Tariff or Quota?

• Both options reduce Japanese cars sales to their original levels and the price of a Japanese car rises to P* -- American car buyers are equally worse off (pay more for less).

• In both options, the number of Japanese cars fall by the same amount, the impact on American car makers should be the same. What is the that impact? Are they happy?

• The tariff raises tax revenues (T x Qo) that could be used to compensate US citizens, BUT Japanese car makers are selling the same quantity of cars they did prior to rise in gas prices for less? Aren’t they going to be mad?

• With the quota, Japanese car makers are selling the same amount of cars they did before the rise in gas prices for more money? Aren’t they happy?

Question 6 (Problem 9):The U.S. government would like to help the American auto industry

compete against foreign automakers that sell trucks in the United States. It can do this either by imposing a quota on the number of foreign trucks imported or by imposing an excise tax on each foreign truck sold in the United States. The hypothetical demand and supply schedules for imported trucks are given in the following table:

Question 5 (Problem 7)• Question:For the last 70

years the U.S. government has used price supports to provide income assistance to American farmers. At times the government has used price floors, which it maintains by buying up the surplus farm products. At other times, it has used target prices, a policy by which the government gives the farmer an amount of money equal to the difference between the market price and the target price for each unit sold. Consider the market for corn depicted in the accompanying figure.

Question 7 (Problem 11)

a. Consumers Producers

Pretax $50 $50

Postax $55 $30

CHANGE $5 $20

TAX = $5 + $20 = $25

$20 > $5 incidence on producers