Government has various policy tools to affect price, quantity, supply curve and demand curve. This chapter considers: 1. Price Controls 2. Taxes 1. Price Controls can be either a. Price Ceilings - The price cannot exceed a certain upper limit or b. Price Floors - The price cannot go below a certain limit.

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First consider a price ceiling. For it to be binding, i.e. to change the price from what it would have been without the ceiling, the price ceiling must be below the equilibrium price.

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If the price ceiling lies above the equilibrium price, the price ceiling is not binding – it does not affect the price.

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When there is a binding ceiling, the price is lower than the equilibrium price. The amount that buyers are willing to buy at the ceiling price is larger than the amount sellers are willing to sell at that price – there is a shortage of size Qb − Qs .

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Sellers would like to raise the price above the price ceiling and make more revenue, but they are restricted by law. The price remains at the price ceiling. There is only Qs of the good, but buyers want Qb > Qs of it. How does the good get rationed among all the buyers who want it? One way is through lines. People who come early will get the good and people who come late will not. Another way to ration the good is for sellers to sell only to their friends. Neither of these rationing mechanisms are desirable. Waiting in lines wastes people’s time and is thus inefficient. Discrimination to decide who gets to buy the good is also inefficient because the good need not go to those who value it most. Who benefits and who loses from the binding price ceiling? Sellers of the good lose – they get less revenue due to a lower price and lower quantity sold. Those buyers of the good who can buy it gain by being able to get the good at a lower price than without the price ceiling. Those buyers who don’t get to buy the good, but would have bought it without the price ceiling lose – their valuation of the good is equal to or higher than what they would have paid. Examples of real-life price ceilings In 1973 OPEC raised the price of crude oil in world markets. This resulted in long lines at gas stations. How did this happen? The American government had installed price ceilings for gasoline before OPEC raised the price of crude oil. Initially the price ceiling was not binding.

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When the price of crude oil rose, the supply curve for gasoline shifted to the left because crude oil is the major input in gasoline. It rose to be above the price ceiling. This made the price ceiling bind.

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Eq price before

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So before the supply shift, the price ceiling was not noticeable. The supply shift and price rise made it noticeable. The price ceiling was eventually repealed. While it may have helped those people who got the gas for a cheaper price than they would have otherwise, it made many people waste time standing in lines. Rent control Many cities have rent control – a price ceiling on rents that landlords charge tenants. The goal is to help the poor by making housing affordable to them. Short run vs long run effects of rent control i. Short run effects – supply curve vertical (perfectly inelastic), demand curve inelastic 7

So landlords have to rent at those prices if they rent at all. Not such a big gap between demand and supply.

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ii. Long run effects – supply curve and demand curve more elastic. Landlords don’t build new apartments due to low rent, don’t maintain their apartments, maybe don’t rent out their existing apartments and keep them empty or live there themselves. Renters respond to lower prices more strongly as well. More people move to city attracted by low rents.

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A larger difference between quantity supplied and quantity demanded in long run.

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So the rent control causes long-run supply to decrease by a lot due to the elasticity of long-run supply curve, and causes long-run demand to increase by a lot due to long-run elasticity of demand curve. How do the rent-controlled apartments get allocated? i. Passed down among people who know each other or across generations of a family. ii. Discriminatory allocation of apartments iii. Under the table payments made – brings price closer to market equilibrium price. Solutions to providing affordable housing to low-income people?

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Allow rent price to be equilibrium price, but provide subsidies to the poor for housing. Government builds low rent housing for poor. b. Price floors If the equilibrium price is above the price floor, the equilibrium price is the price. If the equilibrium price is below the price floor, the price floor is the price.

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When there is a binding price floor quantity supplied exceeds quantity demanded at that price – there is a surplus. Some sellers are not able to sell all they want at the price. Example: The minimum wage Workers are ”sellers” of their labor. Employers are ”buyers” of labor. Thus the minimum wage is a price floor for the price of labor. 10

First minimum wage in US enacted by Congress with Fair Labor Standards Act 1938. Under President FDR. In 2005 min wage was $5.15 hour. Starting July 24, 2008 min wage is $6.55. State min wages vary – Washington’s is $8.07, Minnesota $5.25 for small businesses (but federal min wage is in effect there). Sometimes lower for tipped employees. Result of a binding minimum wage is higher amount supplied than demanded at the going price: Unemployment. Economy consists of many labor markets with different equilibrium wages. Only those with equilibrium wages below the price floor are affected by the price floor. Teenage workers most affected by minimum wage changes, because they are among least skilled and least experienced workers. Studies find: A 10 percent increase in minimum wage decreases teenage employment between 1 to 3 percent. However, 10 percent increase in minimum wage doesn’t increase average wage of teenagers by 10 percent because some are working at equilibrium wages above minimum wage, others paid under the table. Higher minimum wage affects number of teenagers looking for jobs. When min wage rises more teenagers drop out of school to get jobs. To find the full effect of minimum wage changes on the economy, must use a general equilibrium model: Take into account the demand changes by those who are getting the minimum wage as well as those unemployed due to minimum wage.

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