Government Control of Prices in
Mixed Systems
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.
CONTROLS ON PRICES
 Are usually enacted when policymakers believe the market
price is unfair to buyers or sellers.
 Examples: price ceilings and floors.
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 way to
destroy a city, other than
bombing.”
Demand for Housing
 The demand curve shows the
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
Rent
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
Supply
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
 What are the actual effects?
Effect of Rent Control
Rent
 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
Rent
Control
Shortage
Demand
0
9
Quantity
supplied
11
Quantity
demanded
Quantity
Effect of Rent Control
Rent
 Rent is not low for everyone
Supply
 Since a rent higher than
$400 is illegal, the market
cannot work to allocate the $500
housing units among people.
 Illegal payments to landlords
400
 Rent is higher in non rent
controlled areas
0
Rent
Control
Shortage
Demand
9
Quantity
supplied
11
Quantity
demanded
Quantity
Effect of Rent Control
 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
contributes to
homelessness
Effect of Rent Control
 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:
 Who benefits?
 Effects on the labor market? on poverty?
 Objective: Understand how wage is
determined in a free market
 Demand for labor is downward
sloping
 Demand for labor is a derived
demand
Wage
Labor Demand
Labor
demand
Quantity of
Labor
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, which
is the marginal benefit of
hiring that worker
Labor
Total
Product
0
0
1
5
2
25
3
50
4
70
5
80
6
85
7
86
Marginal
Product
MRP
Deriving Labor Demand
 As additional workers are
hired output increases at a
decreasing rate
 The additional output, i.e.,
Marginal Product, eventually
declines
 This is referred to as the law
of Diminishing Marginal
Product
 Assume price= $0.5
Labor
Total
Product
0
0
1
Marginal
Product
MRP
-
-
5
2.5
20
10
25
12.5
20
10
10
5
5
2
25
3
50
4
70
5
80
6
85
5
2.5
7
86
1
0.5
Deriving Labor Demand
 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:
MRP >=W
Labor Demand
 If W=2.5, How many 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
MRP
5
Labor
Demand
2.5
1
5
6
Quantity of
Labor
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
General Conclusion: Labor supply is upward sloping
How the Minimum Wage Affects the
Labor Market
Wage
Labor surplus
(unemployment)
Labor
Supply
Minimum
wage
Equilibrium
wage
Labor
demand
0
Quantity
demanded
Quantity
supplied
Quantity of
Labor
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
 Research 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.
TAXES
 Governments levy taxes to :
 raise revenue for public projects
 Change market price to reduce trade in a particular good
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, 𝑃𝐵 .
 The price that sellers receive, 𝑃𝑆 .
 The difference between the two is the tax, t.
 Let’s first consider a tax on sellers.
A Tax on Sellers
Price
S2
Price sellers accept
under the tax
S1
3.00
1.30
A tax on sellers
shifts the supply
curve upward
by the amount of
the tax ($0.50).
Tax ($0.50)
0.80
Price
Sellers accept
before the tax
Demand, D1
0
30
100
Quantity of
Ice-Cream Cones
A Tax on Sellers
Price of
Ice-Cream
Cone
S2
𝑃𝐵
Price
Before tax
$3.30
3.00
2.80
S1
Tax ($0.50)
𝑃S
Demand, D1
0
90
100
Quantity of
Ice-Cream Cones
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
Winners:
government revenue
Tax wedge
($0.5)
The tax results in a
reduction in quantity
Price sellers
Receive
($2.8)
D
0
Qt
Quantity