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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