Government Control of Prices in What Are the Actual Outcomes? Chapter 3 Government Control of Prices in Mixed Systems: What Are the Actual Outcomes? McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

Key Concepts Price ceilings Price floors Rent controls Minimum wages Shortages Surpluses Derived demand Marginal product of labor Marginal revenue Substitution effect Income effect

Price Ceiling and Price Floor Price ceiling is the maximum allowable price for a good or service set by the government or a group of sellers Holding inflation in check Keeping prices affordable for poorer part of population Price floor is the minimum allowable price for a good or service set by the government or a group of sellers Minimum wage laws

Rent Controls Why would people live in slums? Do the rent controls serve best interests of low-income groups? What are the ways out of the poor’s housing problems?

Demand for Housing Each household allocates its income in such a way that a dollar’s worth of housing contributes the same to its well-being as a dollar’s worth of anything else it buys At the a level that is higher than the equilibrium one, a dollar’s worth of housing is a smaller quantity of housing than before Alternatively, an additional dollar’s worth of housing contributes less to the household’s well-being than before The contribution of an additional dollar to buying anything else but housing is greater than before Rational households will thus shift their consumption away from housing and into something else The decrease in demand for housing happens due to: Sharing Moving in back with families Relocating further away

Supply of Housing Supply for housing is not very responsive to movements in price As a result, the supply curve is relatively sharp It takes several years to significantly increase the existing stock of housing

Supply and Demand for Housing Rent per unit $ S D B 600 A 500 400 8 10 11 Quantity (thousands of units per year)

Housing Prices Suppose economic growth and rising housing rentals shift the demand curve for housing outwards (to the right) Given the inability to build new housing units quickly, housing prices will rise fairly fast in the short run Rise in rental rates makes investment in housing more profitable As a result, the supply curve for housing will shift to the right in the long run Since typically housing demand outpaces the growth in housing supply, the outcome will be characterized by Greater amount of housing available Higher rental rates

Rent Control Rent per unit $ S1 D1 D S 800 600 525 500 10 11 12.5 13 Quantity (thousands of units per year)

Effects of Rent Controls What are the actual effects of rent controls? Most important effect of rent controls is housing shortage If the rent controls are set below the equilibrium level, not all households looking for apartments are able to find them Under-the-table payments Housing costs increases for commuters: Direct costs of commuting Value of time lost in commuting The long-run profit inducements that would shift the supply curve for housing outwards are eliminated by rent controls Homeless population increases due to the decreased supply Landlords tend to allow the quality of their housing units to deteriorate The price of housing no longer reflects the value of housing for the households  misallocation of resources

Minimum Wages Most people view favorably the laws on minimum wages What are the economic effects of the minimum? Does the minimum serve to improve the distribution of income in the country? We need to address the way in which the labor market functions to answer these questions

Market Demand for Labor Derived demand for labor: The demand for labor is said to be dependent on, or derived from, the demand for the product being produced Employers do not demand labor because they receive direct satisfaction from labor but because employing labor leads to satisfaction indirectly in the form of increased revenues when employers sell the products produced by labor As more labor is hired, the value of an additional worker to the employer declines  the downward-sloping demand curve for labor

Minimum Wages - Market Demand for Labor Wage rate ($) D 4.00 3.50 3.00 2.50 2.00 1.50 1.00 .50 D 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 (Quantity (thousands of hours per week) 3-13

Demand for Labor by One Employer Marginal revenue product of labor: the increase in revenue that accrues to the firm when an additional worker is hired, indicating the value of the worker to the firm Marginal product of labor: the increase in revenue from selling an additional unit of the product Law of diminishing returns: as additional units of a variable input are added to a given amount of a fixed input, the resulting increases in output eventually will decline

The Demand for Labor by One Employer (1) (2) (3) (4) (5) Units of Labor Total Production Marginal Product Marginal Revenue Marginal Revenue Product MRP = (3) x (4) 1 5 $.50 $2.50 2 25 20 10.00 3 50 12.50 4 70 80 10 5.00 6 85 2.50 7 86 .50 3-15

The Demand for Labor by One Employer Rational Demand for Labor 12.50 10.00 5.00 2.50 .50 1 2 3 4 5 6 7 Quantity of Labor

Demand for Labor Benefits of specialization result in increasing marginal product of labor when a few people are hired Diminishing returns to labor, however, eventually come into being Firms typically have a fixed number of tools so increasing employment means sharing tools and their inefficient use “Too many cooks spoil the broth” Overspecialization leads to workers being bored, distracted and less efficient

Marginal Product, Revenue and Revenue Product Initial increase of marginal product: with only one worker there is too little labor for the amount of capital that the firm has at its disposal (the firm’s capital is underutilized) Hiring the second worker allows to use capital more efficiently Capital can be overutilized as well, leading to the decreasing marginal product of labor (“too many cooks spoil the soup”) Overspecialization of labor can also result in diminishing returns

Market Supply of Labor The supply curve of labor tells us what happens to the hours of work offered by an economy’s workers as the wage changes Does the amount of working hours increase as the wage increase? Substitution effect: the change in the hours of work that occurs in response to a wage change, other things being equal (wage is price of leisure, so that rising wages result in more working hours) Income effect: a measure of the change in the hours of work that occurs when there is a change in income, other things being equal (income effect treats leisure as a normal good, demand for leisure increasing as income increases)

Market Supply of Labor Substitution Effect Income Effect Wage rate ($) 4.00 3.50 3.00 2.50 2.00 1.50 1.00 .50 Substitution Effect Income Effect S 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Quantity (thousands of hours per week)

Effects of Wage Increase An increase in wages results in increased demand for leisure since leisure is a normal good As a result, the supply curve of labor due to income effect alone should be negatively sloped However, the substitution effect (leisure versus income) dominates, so that the supply curve for labor is normally positively sloped

Effects of Minimum Wage If the wage rate is higher than the marginal revenue product of labor, the employers will higher less labor Whenever minimum prices are set above the market equilibrium, they result in a surplus called unemployment Effects of minimum wages Quantity of labor demanded falls Quantity of labor supplied increases

Effects of the Minimum Wage Wage rate ($) D S 6.00 5.00 S D 8.5 9 9.25 Quantity (thousands of hours per week)

Minimum Wages and Poverty Is the minimum wage an effective antipoverty tool? By how much do minimum wages increase unemployment? To what extent does the minimum wage improve distribution of income in the economy?

Minimum Wages and Poverty The minimum had fallen to only 36% of average earnings As an antipoverty tool, the minimum is not particularly potent Unemployment effects of minimum wages are unclear

Alternative Analysis of the Minimum Wage Wage rate ($) D 6.00 5.00 S D 9 Quantity (thousands of hours per week)

Alternative Analysis of the Minimum Wage Vertical portion of the demand curve Higher wages are offset by longer queues Improvements in operating efficiency Raising prices on items with inelastic demand Avoiding hiring and training costs Vertical portion of the supply curve For low wage earners, the number of hours worked may be more important than the wage rate Income and substitution effects exactly offset each other Minimum wages may have little or no effect as long as we are on the vertical part of the demand and supply curve