Download lecture_6 - kingscollege.net

Lecture 6
Market Values and Government Intervention
Readings: Chapter 6
Why do governments intervene to alter
market prices?
There are two reasons:
1. Unfairness of market prices
2. Belief that the market may have failed
to provide efficient prices (market
failure)
How do governments intervene in the
marketplace?
• 1. Market regulation
• Competition regulation
• Price regulation
• Quantity regulation
• Quality Regulation
• Criminalization of consumption
• 2. Taxation and transfer
• 3. Public production and provision.
Example: The April 1906 San
Francisco Earthquake
• Earthquake and subsequent fire left 200 000
homeless (50% of population), creating
tremendous hardship. The government did
virtually nothing to solve the problem.
• Q: What happened Next?
• A: One month later:
– No mention of housing shortage
– 64 offers of houses/flats for rent
– 19 of houses for sale
Rent (dollars per unit per month)
The San Francisco
Housing Market in 1906
SSa
24
SS
20
Long-run
adjustment
After Earthquake
LS
16
D
12
0
72
100
150
Quantity (thousands of units per month)
What if government had
regulated to prevent profiteering?
Price ceilings are
regulations that make
it illegal to charge a
price higher than a
specified level.
Rent ceilings are price ceilings applied to
housing markets.
A Regulated Housing Market
• The price ceiling has several undesirable sideeffects.
• Shortages create homelessness.
• Search activity (time spent looking for someone to
do business) rises as more time and resources are
devoted to apartment-hunting
• Black market emerges in which prices illegally
exceed the price ceiling. Legal loopholes are also
exploited (“key money”/ damage deposits/ etc.).
• No New construction choked because of low prices.
• Dead-Weight Loss
Rent (dollars per unit per month)
A Rent Ceiling
Maximum
black market
rent
SSa
24
20
Rent ceiling
16
Housing
shortage
12
0
44
72
100
D
150
Quantity (thousands of units per month)
Rent (dollars per unit per month)
Inefficiency of Rent Ceilings
Consumer surplus
30
Search
activity
24
S
Deadweight
loss
20
Rent ceiling
16
12
0
D
Producer
surplus
44
72
100
150
Quantity (thousands of units per month)
Example: Poverty is high in Canada
• http://www.economist.com/node/17581844
• Why are there so many poor people in
such a rich country?
– Advances in technology have reduced the
demand for low-skilled labour.
– In the short run lower demand causes wages to
fall. Fewer people will want to work. Supply and
demand on the labour market will be equalized.
– The recession has further reduced the demand
for low skilled workers
Wage Rate (dollars per hour)
A Market for Low-Skilled
Labour
SS
6
5
After invention
4
D
3
DA
20
21
22
23
Quantity (millions of hours per year)
What will happen if the government
does nothing?
• In the long run people can acquire new skills
and find new types of jobs:
– This will cause people to leave the low-skilled
labour market
– As supply to declines, wages rise.
• The longer the period of adjustment, the
greater the elasticity of supply of labour.
Wage Rate (dollars per hour)
A Market for Low-Skilled
Labour
SS”
6
SS’
SS
5
After invention
Long-run
adjustment
4
D
3
DA
20
21
22
23
Quantity (millions of hours per year)
Wage Rate (dollars per hour)
A Market for Low-Skilled
Labour
SS
6
LS
5
After invention
Long-run
adjustment
4
D
3
DA
20
21
22
23
Quantity (millions of hours per year)
What else could the government do?
• A minimum wage law is a price floor
regulation that makes the hiring of
labour below a specified wage illegal.
• If the minimum wage is set below
equilibrium, it will have no effect.
• If the minimum wage is set above
equilibrium, it prevents price from
regulating quantity supplied and
demanded.
Wage Rate (dollars per hour)
Minimum Wage and
Unemployment
SS
6
Unemployment
5
a
b
Minimum
wage
4
3
DA
20
21
22
23
Quantity (millions of hours per year)
Unintended Impacts:
There are several:
1.
2.
3.
4.
5.
Surplus of workers (unemployment)
Increased search costs
Deadweight Loss
Black Market (Unregulated Sweatshops)
Reduced incentive to acquire new skills.
1. Who will pay the tax?
• Suppose a 10% sales tax is imposed on
the sale of the CD players.
• Introduction of a sales tax means there are
two prices for CD players: an after-tax
price faced by buyers, and a before-tax
price faced by sellers.
• Will the price faced by buyers increase
10% after introducing the sales tax? Will
the price faced by sellers change?
Example: Suppose a new government proposes
a new tax to fund transfers to help the poor.
•
•
What should the government tax?
The decision will depend on:
1. Who will pay the tax. Some groups are better
able to lobby for tax reductions.
2. How lucrative the tax is.
3. The efficiency cost of the tax.
The Sales Tax
Price (dollars per player)
S + tax
S
110
$10 tax
105
100
Tax
revenue
Deadweight
loss
95
DA
3
4
5
6
Quantity (thousands of CD players per week)
Who pays the tax?
• The division of the tax burden between
buyer and seller depends on:
– 1. Elasticity of demand
– 2. Elasticity of supply
• This division of the tax burden is called the
tax incidence.
Price (dollars per dose)
Sales Tax and the
Elasticity of Demand
S + tax
Buyer pays
entire tax
S
2.20
Perfectly inelastic
demand
2.00
D
100
Quantity
(thousands of doses per day)
Price (cents per pen)
Sales Tax and the
Elasticity of Demand
S + tax
S
1.00
Seller
pays
entire
tax
Perfectly elastic
demand
0.90
1
4
Quantity (thousands of marker pens per week)
Price (cents per pound)
Sales Tax and the
Elasticity of Supply
Perfectly Elastic
Supply
S + tax
11
10
Buyer
pays
entire
tax
S
D
3
5
Quantity (thousands of
kilograms per week)
Price (dollars per bottle)
Sales Tax and the
Elasticity of Supply
S
50
Seller pays
entire tax
Perfectly
inelastic
supply
45
D
100 Quantity (thousands of bottles per week)
Tax Incidence
• In the usual case, demand is neither
perfectly inelastic nor perfectly elastic.
• This means that the tax is generally split
between buyer and seller.
• The more inelastic the demand, the
more the buyer pays.
• The more elastic the supply, the larger
is the amount of tax paid by the buyer.
How lucrative will a tax be?
• Low elasticity of demand
equals high revenue.
(alcohol, tobacco, and
gasoline).
• High elasticity of demand
equals low revenue.
Price (dollars per player)
Tax revenue and elasticity
130
S + tax
S
105
100
95
D, elastic
75
D, inelastic
0 1
2
3
4
5
6
7
8
9
10
Quantity (thousands of CD players per week)
What is the Efficiency Cost
of a Tax?
• Sales taxes place a wedge between the
buyers’ price and the sellers’ price.
– The marginal benefit of the buyer does not
equal the marginal cost of the seller. This
creates inefficiency.
• The more inelastic is demand or supply, the
smaller the decrease in quantity and so also
the smaller the deadweight loss.
Price (dollars per player)
Taxes and Efficiency
130
105
100
95
Consumer
surplus
S + tax
S
Deadweight
loss
Tax
Revenue
75
0 1
D
Producer
surplus
2
3
4
5
6
7
8
9
10
Quantity (thousands of CD players per week)
Price (dollars per player)
Taxes and Efficiency
130
S + tax
S
105
100
95
D, elastic
75
D, inelastic
0 1
2
3
4
5
6
7
8
9
10
Quantity (thousands of CD players per week)
Bottom Line
• Governments like to tax inelastically
demanded goods because:
– tax falls on poorly organized consumers, and
not on well organized producers.
– Dead-weight loss is lower
– Revenue is higher
• Policies to help the poor are more
expensive than the tax revenue required to
fund them.
Example: The war on drugs
• Suppose the government is concerned with solving
the social problem of drug addiction by outlawing the
trade in drugs.
• We can apply the same principles to analyzing the
markets for illegal goods as used to examine trade
in legal goods.
• When trading in a good is made illegal, the costs of
trade change.
• The structure of penalties and the effectiveness of
enforcement policy determines the extent to which
these costs change.
Price
A Market for an Illegal
Good
Pc
Cost per unit
of breaking
the law...
…to
buyer
S + CBL
S
d
c
…to
seller
D
D - CBL
Qp
Qc
Quantity
How effective was the war on drugs?
• The evidence suggests it was ineffective.
• The US strategy focused on increasing penalties
and enforcement for drug dealing. Occasional
consumers were not targeted for criminal
prosecution - unless they were black.
• Because addicts have inelastic demand, such a
strategy is doomed to have very little impact on
drug consumption.
• It has also had the unintended consequence of
dramatically increasing revenue earned by criminal
enterprises that sell illicit drugs.
US War on Drugs
Price
S + CBL
S
Pc
c
D
Qc
Quantity
Unintended Consequences?
• The war on drugs raised the street price of
addictive substances without reducing
consumption by very much.
– Addicts turned to theft to support their habits.
– Criminal organizations became larger,
wealthier and more heavily armed.
– Columbia, Peru, and Afghanistan became
dominated by the criminal drug industry.
Example: Farm Crises.
• Bad years (low prices,
poor harvests) push
many farms over the
brink into bankruptcy.
• Governments are
expected to help solve
periodic farm crises.
Why do farm crises occur?
• There are two causes:
– Short-run supply is inelastic and tends to shift
dramatically due to climatic variation.
– Demand is inelastic.
• Result:
– Output, prices and revenue are highly volatile
– Poor crops can mean bankruptcy.
– Good crops may be undermined by low prices.
Harvests, Farm Prices,
and Farm Revenues
Price (dollars per tonne)
MS1
MS0
400
Poor
harvest
300
$1.5 billion
200
100
0
$3.0 billion
5
10
$1.0
$1
billion
billion
15
20
D
25
Quantity (millions of tonnes per year)
Harvests, Farm Prices,
and Farm Revenues
Price (dollars per tonne)
MS0
MS2
400
300
Bumper
harvest
200
$2.0 billion
billion
$2.0
100
$2.0 billion
0
5
10
D
$0.5
billion
15
20
25
Quantity (millions of tonnes per year)
What reduces price and
revenue volatility?
Two social mechanisms can stabilize farm
revenue:
1. Speculative markets in inventories
2. Government Farm price stabilization policy
Price (dollars per tonne)
How Inventories Limit Price
Changes
Q1
Q2
400
When production
increases….
300 When production
decreases...
S
200
100 …take 5 million from
D
inventory...
0
5
10
15
20
Inventory
25
…send 5 million
to inventory...
Quantity
(millions of tonnes)
Farm Revenue
• Speculative markets in inventories do not
stabilize farm revenue. Instead, they
stabilize the price at which production can
be sold.
– When price is stabilized, revenue fluctuates
as production fluctuates.
– Bumper crops bring larger revenues than do
poor harvests.
Farm Marketing Boards
• A number of different policies are used by
farm marketing boards to stabilize farm
prices and farm revenues.
– Quotas restrict the quantity produced by limiting
entry into the industry. They act to stabilize
supply and increase farm prices.
– Price floors are supported by governments in
Europe. When set above equilibrium price level,
these create surpluses, which the government
must purchase and dispose of to prevent the
price from falling.
Impact of Quota
Price (dollars per tonne)
SQuota
400
300
Quota
Value
SLR
200
100
0
D
5
10
15
20
25
Quantity (millions of tonnes per year)
Unintended Consequences?
• The quota will become extremely valuable.
Old farmers will make a windfall profit
• Young farmers will be even more indebted
because of the necessity of buying quota.
• Poor consumers face higher food costs.
• Huge deadweight loss.
Price (dollars per tonne)
Impact of Price Floor
400
SLR
300
PFloor
200
Cost
100
D
0
5
10
15
20
25
Quantity (millions of tonnes per year)
Summing Up
• Government is under great pressure to
correct the perceived unfairness of the
marketplace.
• Problem: government regulatory solutions
often have unintended consequences that
may be worse for fairness and will
certainly hurt efficiency.
• In later lectures we will look at when and
how government interventions can
improve efficiency and fairness.
The End