Supply, Demand, and Government Policies 6 Supply, Demand, and Government Policies

Controls on Prices Evaluating price controls Markets are usually a good way to organize economic activity Economists usually oppose price ceilings and price floors Prices – coordinate economic activity

Market Failure Unregulated (“free”) markets are usually a good way to organize economic activity But not always – an example of market failure As CEO of Turing, Shkreli hiked the price of the drug Daraprim from $13.50 a pill to $750 overnight. "We raised the price from $1,700 per bottle to $75,000 ... So 5,000 paying bottles at the new price is $375,000,000 Market power – patent -> monopoly

The market for gasoline with a price ceiling 2 The market for gasoline with a price ceiling The price ceiling on gasoline is not binding (b) The price ceiling on gasoline is binding Price of Gasoline Price of Gasoline 2…but when supply falls… S2 1. Initially, the price ceiling is not binding … Demand Demand Supply, S1 S1 P2 Price ceiling Price ceiling QS QD 3…the price ceiling becomes binding… 4. …resulting in a shortage P1 P1 Q1 Q1 Quantity of Gasoline Quantity of Gasoline

Lines at the gas pump Price Ceiling – Not Binding then Binding 1973, OPEC raised the price of crude oil Reduced the supply of gasoline Long lines at gas stations What was responsible for the long gas lines? OPEC: created shortage of gasoline U.S. government regulations: price ceiling on gasoline Before OPEC raised the price of crude oil – pre-1973 Equilibrium price - below price ceiling: no effect When the price of crude oil rose Equilibrium price – above price ceiling: shortage

A market with a price floor 4 A market with a price floor (a) A price floor that is not binding (b) A price floor that is binding Price of Ice Cream Cone Price of Ice Cream Cone Surplus Supply Demand Supply Demand $4 Price floor 80 120 $3 3 Equilibrium price 100 Equilibrium price 2 Price floor Equilibrium quantity Quantity demanded Quantity supplied Quantity of Ice-Cream Cones Quantity of Ice-Cream Cones In panel (a), the government imposes a price floor of $2. Because this is below the equilibrium price of $3, the price floor has no effect. The market price adjusts to balance supply and demand. At the equilibrium, quantity supplied and quantity demanded both equal 100 cones. In panel (b), the government imposes a price floor of $4, which is above the equilibrium price of $3. Therefore, the market price equals $4. Because 120 cones are supplied at this price and only 80 are demanded, there is a surplus of 40 cones.

Agricultural Price Supports Market price is set by Government at > equilibrium price (binding) Price is “supported” as Gov’t buys up the surplus Thus price will not drop due “normal” market forces (surplus)

Impacts of a Price Support Inefficient Production MC(C) > MV(D) Transfer CS-PS Transfer Due to Increased Production Increased PS

Consequences of Binding Price Supports Compared to a “free” market (unregulated) Consumers buy less milk Lost Consumer Surplus Producers Gain lost consumer surplus (transfer to Producers) Increased milk production (> old equilibirum) Get even more producer surplus Produced inefficiently Value (marginal benefits) of additional milk to consumers < increased (marginal) costs of resources used to produce it And then there are the taxes to pay for it

What Do We Do With the Surplus Surplus milk bought by the Government Give it to Low Income Decreases Private Sector Demand (Nbuyers) Increases amount of surplus milk to be bought Make cheese from it No effect on Milk market price Strategic Cheese Reserve at Hanford Transfer to 3rd World countries Powdered Milk Disrupts their dairy industry

What Could Go Wrong? The Complete Stupidity Of The Looming Dairy Cliff: Milk To ... www.forbes.com/.../the-complete-stupidity-of-the-looming-dairy-... Forbes Dec 31, 2012 - That will compel the Department of Agriculture to roughly double the price supports for dairy and other farm products thanks to a mystical  Dairy Price Supports: Still Milking the Public www.cato.org/.../dairy-price-supports-still-milking-public Cato Institute Why $7-Per-Gallon Milk Looms Once Again : The Salt : NPR www.npr.org/sections/.../why-7-per-gallon-milk-looms-once-againNPR

An Economist’s Perspective Cato Institute http://www.cato.org/pubs/tbb/tbb_0707_47.pdf The federal government has subsidized and regulated the dairy industry since the 1930s. A system of “marketing order” regulations was enacted in 1937. A dairy price support program was added in 1949. An income support program for dairy farmers was added in 2002. As part of this year’s farm bill, Congress may reauthorize dairy programs, but they are among the most illogical of all farm programs. The government spends billions of dollars reducing food costs through programs such as food stamps, yet dairy programs increase milk prices.

Cost of Price Supports In 2013, the U.S. Department of Agriculture spent $107 million buying sugar to increase prices to producers Other Agricultural Price Support Programs Wheat Corn Milk and milk products

Cost of Price Supports The U.S. government has been protecting farmers against unpredictable hardships such as bad weather since the 1930s, when drought and the Great Depression devastated the nation's agriculture industry. Today, agricultural subsidies and insurance cost the U.S. taxpayers about $20 billion annually, according to the U.S.

Agricultural Price Supports in the 3rd World Agricultural price supports often stimulate larger production, tax consumers, and impede international trade. They often transfer income from lower-income consumers to wealthier owners of farmland. Price supports do little to help farmers with below-average incomes because benefits are distributed in proportion to sales. A more efficient and equitable way to help low-income farmers would be to transfer income to them directly. Agricultural Price Supports by Robert L. Thompson

Agricultural Price Support Programs in the US The Economist labeled the recently enacted 2008 farm bill “A Harvest of Disgrace” (May 24, 2008). The five-year $307 billion bill, through a complicated system of government programs, lavishes cash on upper-income farm households. The major beneficiaries of U.S. agricultural programs, commercial farmers, will have an average income of some $230,000 in 2008, according to the U.S. Department of Agriculture (USDA). The main restriction on these subsidies is a means test that applies to couples making more than $1.5 million per year. A host of “emergency programs” was enacted as part of President Franklin Roosevelt’s New Deal during the Great Depression of the 1930s. Despite huge changes over time in the particulars, the programs affecting the growing and marketing of farm crops remain largely intact.

Agricultural Price Supports – An Economic Analysis https://en.wikipedia.org/wiki/Price_support Price = $5 Quantity = 500 Consumer Surplus = $1,250 Producer Surplus = $1,250 The government agrees to pay $6 per unit, setting market price at $6 At this price: consumers buy 400 units producers supply 600 units To maintain a price of $6 per unit, the government buys the surplus of 200 units Consumer Surplus decreases to $800 Producer Surplus increases to $1,800

How the minimum wage affects the labor market 5 How the minimum wage affects the labor market (a) A free labor market (b) A Labor Market with a Binding Minimum Wage Wage Wage Labor supply Labor supply Labor surplus (unemployment) Labor demand Labor demand Minimum wage Quantity demanded Quantity supplied Equilibrium wage Equilibrium employment Quantity of Labor Quantity of Labor Panel (a) shows a labor market in which the wage adjusts to balance labor supply and labor demand. Panel (b) shows the impact of a binding minimum wage. Because the minimum wage is a price floor, it causes a surplus: The quantity of labor supplied exceeds the quantity demanded. The result is unemployment.

Impact of the minimum wage Workers with high skills and much experience Not affected: Equilibrium wages - above the minimum Minimum wage - not binding Teenage labor – least skilled and least experienced Low equilibrium wages Willing to accept a lower wage in exchange for on-the-job training Minimum wage – binding