Ch 3 – Government Control of Prices

1. Ch 3 – Government Control of Prices The free enterprise system is absolutely too important to be left to the competitive forces of the marketplace. A U.S. Senator

2. In market systems, prices result from interaction of market forces. • In mixed systems, market forces are not always allowed to operate unhindered. • Some prices are under legal control of government. Ch 3 – Govt. Price Controls Minimum prices are set to benefit sellers of goods. Maximum prices are set to benefit buyers of goods.

3. Ch 3 – Govt. Price Controls • Are these controls effective? • Do they achieve the intended results? • Do they improve the market, maximize well being?

4. Price Ceilings Ch 3 – Govt. Price Controls • Maximum prices allowed by law • Must be below equilibrium to be effective. • Two main purposes: • Keep inflation in check • Keep prices of certain goods and services within reach of lower income people.

5. Ch 3 – Govt. Price Controls PC QD QS Price Ceilings P S PE D 0 Q QE

6. Ch 3 – Govt. Price Controls Price Ceilings P S PE Maximum price PC Shortage, QD>QS D 0 Q QE QD QS

7. Price Floors Ch 3 – Govt. Price Controls • Minimum prices allowed by law • Must be above equilibrium to be effective. • Main purpose: • Increase incomes of sellers of the good or service.

8. Ch 3 – Govt. Price Controls Price Floors P S PF PE D 0 Q QD QE QS

9. Ch 3 – Govt. Price Controls Price Floors P S Surplus, QD<QS PF Minimum price PE D 0 Q QD QE QS

10. Ch 3 – Govt. Price Controls P S PE PC D 0 Q QD QS Price Ceilings: Rent Control • Households choose how many dollars to allocate to housing based on incomes, other expenses. • Some larger cities placed ceilings on rent to ensure availability of affordable housing for lower incomes. • Household mobility - If rents increase, households move to smaller places, get roommates, etc. • Produces market shortage of housing. QE

11. Ch 3 – Govt. Price Controls Effects of Rent Control • Housing Shortage • Not all households that want housing at that price can find it. • Housing mobility cannot take place. People don’t leave home, share when they don’t have to, don’t downsize or upsize when they need to. • People live further from employment than they would otherwise. • Costs Not Kept Down for Everyone • “Under table” payments commonly made for available apartments. • “Black Market” • Profit Incentives Removed, Supply Does Not Increase • Other ventures become more profitable than real estate. • Example – Paris – almost no new rental housing built between 1914 and 1950. • Supply decreases in long run as landlords give up and change use of property.

12. Ch 3 – Govt. Price Controls Effects of Rent Control(cont.) • Housing Quality Deteriorates • Lower quality for same price = same quality at higher price. • Landlords cannot afford maintenance. • Resource Misallocation • Households value housing at higher price. • Want MORE resources allocated to housing, not less.

13. Ch 3 – Govt. Price Controls • This is the market for minimum wage labor. • Demand for labor is a derived demand (Demand is dependent on demand for the product being produced). • Employers will hire up to the point where MC=MB (where wage = contribution to output) • Supply curve represents workers available for jobs at various wages. Price Floors: Minimum Wage P (WAGE) S PF PE D 0 Q QD QE QS

14. Ch 3 – Govt. Price Controls Effects of Minimum Wage (Some win, some lose) • Increased Unemployment in Minimum Wage Jobs • Price floor results in surplus of minimum wage labor. • Qty of labor demanded by employers is less than quantity of labor supplied by workers at higher wages. • When required to pay ALL minimum wage workers a higher per person wage, employers will not be able to employ as many workers. • Workers impacted most – young minority males. • Higher Incomes for Minimum Wage Workers Still Employed • Though more workers are unemployed, those that remain employed earn higher wages. • Does Not Impact Poverty Rates • So few of those working for minimum wage are head of households, it does not tend to pull families out of poverty.

15. Ch 4 – Pollution Problems The use of solar energy has not been opened up because the oil industry does not own the sun.Ralph Nader

16. Ch 4 – Pollution Problems “Opie, you haven’t finished your milk. We can’t put it back in the cow, you know.” Aunt Bee

17. Ch 4 – Pollution Problems • Pollution clean-up and prevention is one of the most hotly debated topics in politics, social sciences, natural sciences, AND economics. • How much is too much? Should ALL pollution be prevented? How do we know where to stop?

18. Ch 4 – Pollution Problems What is Pollution? • Services of the Environment • Air, water and land for survival • Habitat, or environment • Resources for production processes by households and firms. • Three Ways Environment is Affected by Use • Exhaustible resources are diminished (coal, oil). • Replaceable resources are used (trees, animals). • Waste from production and consumption is disposed.

19. Ch 4 – Pollution Problems What is Pollution? • Pollution comes primarily from waste disposal • Recycling • Transformation of waste, either naturally or mechanically, into raw materials that can be used again. • Pollution • Waste that is either: • not completely recycled • not recycled fast enough, or • not recycled at all. • Pollution takes place when the capacity of environmental services is diminished.

20. Ch 4 – Pollution Problems Economics of Pollution • Why is pollution a problem? • Property rights are nonexistent or not enforced. • Nobody owns air, rivers, sides of highways. • If owned, owner is not always around to monitor. • Environment’s services are shared by population

21. Ch 4 – Pollution Problems Externalities Externality A cost or benefit imposed on a consumer or a firm by actions taken by others. The cost or benefit is thus generated externally to the consumer or firm. Externalities occur when a third party to the market (someone not directly in the market) is affected by the production or consumption of the good or service. An externally imposed benefit is a positive externality. An externally imposed cost is a negative externality.

22. Ch 4 – Pollution Problems Externalities • Examples of Externalities • Positive: • A well-maintained property next door that raises the market value of your own property. • A pleasant cologne or scent worn by the person seated next to you. • Improved driving habits that reduce accident risks. • A scientific advance. • Negative: • Air and water pollution • Loud parties next door that keep you awake. • Traffic congestion. • Second-hand cigarette smoke suffered by a non-smoker. • Increased health insurance premiums due to alcohol or tobacco consumption.

23. Ch 4 – Pollution Problems Markets and Resource Allocation Demand • Demand curve represents marginal private benefit (MPB) achieved by consumer. • If consumer is the only party to achieve benefits from transactions in this market, marginal private benefit = marginal social benefit. (MPB = MSB) • If third parties outside of the market benefit from transactions, even though they aren’t consuming or producing the good or service, MPB < MSB. • If MPB < MSB, there are positive (or benefit) externalities in consumptionin this market. P D = MPB Q

24. Ch 4 – Pollution Problems MSB (MPB + Externality) Externality Markets and Resource Allocation • EXAMPLE • MARKET FOR VACCINATIONS • There are benefits to parties other than the direct consumers (if you get your shots, I benefit, even though I don’t get my shots). • This demand curve does not measure all of the benefits that result from transactions taking place in this market. • Positive externalities in consumption, so MPB<MSB. Difference is the externality. • Since market doesn’t know about all benefits, resources will be underallocated in this market (not enough vaccinations will be provided by private market). Demand P D = MPB Q

25. Ch 4 – Pollution Problems Markets and Resource Allocation • Supply curve represents marginal private cost (MPC) paid by producers. • If producer is the only party to pay costs from transactions in this market, marginal private cost = marginal social cost. (MPC = MSC) • If third parties outside of the market also pay costs from transactions taking place in this market, even though they aren’t consuming or producing the good or service, MPC < MSC. • If MPC < MSC, there are negative (or cost) externalities in productionin this market. Supply P S = MPC Q

26. Ch 4 – Pollution Problems MSC (MPC + Externality) Externality Markets and Resource Allocation • EXAMPLE • MARKET FOR PAPER • There are costs to parties other than the producers (the process of producing paper creates dirty air and water, affecting neighbors of plant). • Negative (cost) externalities in production, so MPC<MSC. Difference is the externality. • This supply curve does not measure all of the costs associated with transactions taking place in this market. • Since market doesn’t know about all costs, resources will be overallocated in this market (too much paper will be produced by this factory). Supply P S = MPC Q

27. Ch 4 – Pollution Problems Markets and Resource Allocation • EXAMPLE • MARKET FOR PAPER • These demand and supply curve are measuring only the private benefits and private costs associated with this market. • Consumption and production take place at equilibrium point A. • However, there are costs being borne by third parties in this market (pollution created in air and water of neighborhood around factory). These are negative externalities of production. Demand and Supply P S = MPC A PE D=MPB QE Q

28. Ch 4 – Pollution Problems Markets and Resource Allocation • EXAMPLE • MARKET FOR PAPER • New supply curve represents • MPC+ externalities=MSC. • Equilibrium in this market SHOULD be at point B. • Increase in equilibrium price, decrease in equilibrium quantity. • Until externalities are internalized and reflected in the market, there is an overallocation of resources in this market (too much paper being produced). Demand and Supply MSC P S = MPC B A PE D=MPB QE Q

29. Ch 4 – Pollution Problems Externalities When externalities exist, equilibrium does not yield desired resource allocation. Social well-being is not maximized. (Externalities are also called social spill-overs) This is Market Failure ! Government needs to intervene and correct for market failure by internalizing the externalities, to ensure proper allocation of resources

30. Ch 4 – Pollution Problems MSB = MSC MSC > MSB MSB > MSC Economics of Pollution • What are appropriate levels of control? • Cost-Benefit Analysis • Control pollution up to where MSC = MSB. MSC Cost of Abatement MSB Pollution Control

31. Ch 4 – Pollution Problems Pollution Control Policies • Direct Controls • Ban production • Regulate production • Indirect Controls • Taxation • Cost-benefit analysis shows a tax rate that would get optimal results (MSC=MSB) • Pollution Rights Market • Firms allowed to buy and sell government issued licenses granting right to create certain amount of pollution. EXAMPLE Pollution right costs $1000. If Firm A can cut pollution for less than $1000, they do so, then sell right to pollute to Firm B, who cannot cut pollution as cheaply.