Government Intervention
Introduction
We have learned:

The Laws of Supply and Demand are very powerful tools in the right hands

Both supply and demand can be elastic
You will now learn:

Price controls set the maximum or minimum price at which a good can be sold

Tax creates a wedge between what the buyer pays and what the seller receives.

These policies can be analyzed within the model of supply and demand.

We will find that government policies sometimes produce unintended
consequences.
Price Controls

Government price setting is an ancient practice
o O.T. prohibited interest payment of loans to fellow Israelites
o Medieval governments set maximum price of bread

In U.S., we’ve set price of gasoline, apartment rent, unskilled labor wages ($10?)

General price controls during world wars, Korean war, 1971-1973
o WW1

Wheat minimum prices; coal price control; railroads nationalized
o WW2

1942: rubber then gasoline

1943: coupons to attain most commodities; ration books distributed
by ration board
o Korea

1950: massive hoarding and panic buying by
consumers/manufacturers

Inflation skyrocketed almost immediately

January ’51: comprehensive price controls
o 1971: 90 day price freeze lasts for almost 1000 days

Appeals to raise prices generally granted while wages stagnated;
meat shortage; exacerbated oil shortage due to price control; gas
rationing

price ceiling: a legal maximum on the price at which a good can be sold.

price floor: a legal minimum on the price at which a good can be sold.

There are two possible outcomes if a price ceiling is put into place in a market.
o If the price ceiling is higher than or equal to the equilibrium price, it is not
binding and has no effect on the price or quantity sold.
o If the price ceiling is lower than the equilibrium price, the ceiling is a
binding constraint and a shortage is created.

If a shortage for a product occurs (and price cannot adjust to eliminate it),
a method for rationing the good must develop.

Not all buyers benefit from a price ceiling because some will be unable to
purchase the product.
Case Study: Lines at the Gas Pump

Yom Kippur War; 4th Arab-Israeli War; October War; Ramadan War

During 6-Day War, IDF captured Egypt’s Sinai and half of Syria’s G.H.

Sadat wanted to alter status quo (and regain Egyptian pride) with at least limited
victory; and Hafez al-Assad wanted GH for purely strategic purposes (also wanted
release of Gaza and West Bank(Jordan))

Operation “Full Moon” was planned for almost one year

Egypt and Syria effectively camouflaged attack preparations; though the likelihood of
war was understood to be extremely likely

Yom Kippur: abstain from use of fire, electricity, communications, travel, etc.

Golda Meir, on October 6, decided against a pre-emptive attack

Egypt, Syria, and Expeditionary Forces: 1 mil troops, 8,000 armored pieces, 540
aircraft
o (USSR), Saudi Arabia, Libya, Kuwait, Pakistan, etc.

Israel: 400,000 troops, 4700 armored pieces, 440 aircraft
o (United States)

Oct 8, Golda Meir, facing total defeat, authorizes the assembly of 13 tactical weapons

Oct 9, Nixon authorizes Operation Nickel Grass
o Airlift of tanks, artillery, and ammunition

Saudi Arabia, and eventually the rest of OPEC (mostly) enacted an embargo against
oil shipments to United States (and Netherlands); and cut production, causing the
1973 Energy Crisis
o Price quadrupled in just a few months
o U.S. implemented price controls on “old” oil; gasoline rationed; odd-even
rationing
Case Study: Rent Control in the Short Run and the Long Run

The goal of rent control is to make housing more affordable for the poor.

Because the supply of apartments is fixed (perfectly inelastic) in the short run
and upward sloping (elastic) in the long run, the shortage is much larger in
the long run than in the short run.

Rent-controlled apartments are rationed in a number of ways including long
waiting lists, discrimination against minorities and families with children, and
even under-the-table payments to landlords.

The quality of apartments also suffers due to rent control.
Some evidence12:

93% of economists thought in 1990 that rent control reduced quantity and quality
of housing

Rent control leads to:
o Discourages new construction
o Causes abandonment
o Retard maintenance
o Reduce mobility
o Generate mismatch between housing and tenant
o Exacerbate discrimination
o Create black market
o Conversion to owner-occupied buildings
1
2
Edgar Olsen. 1972. An Econometric Analysis of Rent Control. Journal of Political Economy.
Richard Arnott. 1995. Time for Revisionism on Rent Control. Journal of Economic Perspectives.

Estimates of the proportion of the U.S. rental housing stock currently subject to
rent control range from 10- 15 percent.

Tucker (1987) has argued, on both theoretical and empirical grounds, that rent
control has been a major factor in the rise of homelessness.
o If rent control causes excess demand, then undesirable tenants are the
least likely to get housing, and there is surely a high correlation between
those traits associated with undesirability as a tenant and those that make
for susceptibility to homelessness.
o Also, rent control can reduce the stock of low-quality housing, by inducing
upgrading (for rent level decontrol), rehab (to convert to owner
occupancy), and abandonment.

Very good “Soak the Rich” plan
o Costs to landlords roughly twice the benefits to renters
How Price Floors Affect Market Outcomes

There are two possible outcomes if a price floor is put into place in a market.
o If the price floor is lower than or equal to the equilibrium price, it is not
binding and has no effect on the price or quantity sold.
o If the price floor is higher than the equilibrium price, the floor is a binding
constraint and a surplus is created.
Case Study: The Minimum Wage

The market for labor looks like any other market: downward-sloping demand,
upward-sloping supply, an equilibrium price (called a wage), and an equilibrium
quantity of labor hired.

If the minimum wage is above the equilibrium wage in the labor market, a
surplus of labor will develop (unemployment).

The minimum wage will be a binding constraint only in markets where
equilibrium wages are low.

Thus, the minimum wage will have its greatest impact on the market for
teenagers and other unskilled workers.
Milton Freidman on the minimum wage
Thomas Sowell on attempting equality of outcome
More on minimum wage

Minimum wage laws:
o Restrict freedom
o Increases inequality
o Are just plain racist
I hate John Stossel, but Walter Williams is worth listening to.
Evaluating Price Controls

Because most economists feel that markets are usually a good way to organize
economic activity, most oppose the use of price ceilings and floors.

Prices balance supply and demand and thus coordinate economic activity.

If prices are set by laws, they obscure the signals that efficiently allocate scarce
resources.

Price ceilings and price floors often hurt the people they are intended to help.

Rent controls create a shortage of quality housing and provide disincentives for
building maintenance.

Minimum wage laws create higher rates of unemployment for teenage and low
skilled workers.
Taxes
tax incidence: the manner in which the burden of a tax is shared among
participants in a market.
How Taxes on Sellers Affect Market Outcomes

If the government requires the seller to pay a certain dollar amount for each unit
of a good sold, this will cause a decrease in supply.

The supply curve will shift up by the exact amount of the tax.

The quantity of the good sold will decline.

Buyers and sellers will share the burden of the tax; buyers pay more for the good
(including the tax) and sellers
receive less.

Two lessons can be learned here.
o Taxes discourage market
activity.
o Buyers and sellers share the
burden of a tax.
How Taxes on Buyers Affect Market Outcomes

If the government requires the buyer to pay a certain dollar amount for
each unit of a good purchased, this will cause a decrease in demand.

The demand curve will shift down by the exact amount of the tax.

The quantity of the good sold will decline.

Buyers and sellers will share the burden of the tax; buyers pay more for the
good and sellers receive less (because of the tax).
Case Study: Can Congress Distribute the Burden of a Payroll
Tax?

FICA (Social Security) taxes were designed so that firms and workers
would equally share the burden of the tax.

This type of payroll tax will simply put a wedge between the wage the firm
pays and the wage the workers will receive.

It is true that firms and workers share the burden of this tax, but it is not
necessarily 50-50.

Elasticity and Tax Incidence
o When supply is elastic and demand is inelastic, the largest share of
the tax burden falls on consumers.
o When supply is inelastic and demand is elastic, the largest share of
the tax burden falls on producers.
o In general, a tax burden falls more heavily on the side of the market
that is less elastic.

A small elasticity of demand means that buyers do not have good
alternatives to consuming this product.

A small elasticity of supply means that sellers do not have good
alternatives to producing this particular good.