lecture 7 - price effect and government intervention_bi

1

Economics for Banking and Insurance - I

PGDM : 2014 – 16 Term 1 (June – September, 2014)

(Lecture 7)

Topics to Be Covered

• Government Intervention and Market Equilibrium Price Ceiling: Rent Control, Minimum Drug Price

Price Floor: Minimum Wage, Minimum Support Price, Minimum Price

Incidence of Tax: Nominal and Economic Incidence

• We will use the supply/demand model to see how each policy affects the market outcome (the price buyers pay, the price sellers receive, and equilibrium quantity).

3

Price control and Market Equilibrium

• Price ceiling: a legal maximum on the price of a good or service e.g., rent control

• Price floor: a legal minimum on the price of a good or service e.g., minimum wage

4

EXAMPLE 1: The Market for Apartments

Eq’m w/o price controls

P

QD

SRental price of

apts

$800

300Quantity of apartments

5

How Price Ceilings Affect Market Outcomes

A price ceiling above the eq’m price is not binding – has no effect on the market outcome.

P

QD

S

$800

300

Price ceiling$1000

arnab

When the price ceiling is above the equilibrium price, the equilibrium price is still perfectly legal. Just because landlords are allowed to charge $1000 rent doesn’t mean they will – if they do, they won’t be able to rent all of their apartments – a surplus will result, causing downward pressure on the price (rent). There’s no law that prevents the price (rent) from falling, so it does fall until the surplus is gone and equilibrium is reached (at P = $800 and Q = 300).

6


The eq’m price ($800) is above the ceiling and therefore illegal.The ceiling is a binding constraint on the price, causes a shortage.

P

QD

S

$800

Price ceiling$500

250 400

shortage

arnab

In the Housing market with the price ceiling, the actual price (rent) of an apartment will be $500. It won’t be more than that, because any higher price is illegal. It won’t be less than $500, because the shortage would be even larger if the price were lower. The actual quantity of apartments rented equals 250, and there is a shortage equal to 150 (the difference between the quantity demanded, 400, and the quantity supplied, 250).

7


In the long run, supply and demand are more price-elastic. So, the shortage is larger.

P

QD

S

$800

150

Price ceiling$500

450

shortage

8

EXAMPLE 2: The Market for Unskilled Labor

Eq’m w/o price controls

W

LD

SWage paid to

unskilled workers

$4

500Quantity of

unskilled workers

arnab

Note that, now we are not in a product market anymore rather in an input market. Where the firms are acting as buyers and Households are acting as suppliers . Households are supplying the “Labor” and in exchange firms paying the wage simply as the “price” of labor. Assuming competitive labor market, we can apply the basis tools of demand and supply to this market too. That is each firm is paying the same wage to the workers who are exactly identical to each other. Here, we focus on unskilled labor because the minimum wage is not relevant for higher skilled, higher wage workers. So, matching with the product market you can think a worker as a product and is characterized by lower level of skills.

9

How Price Floors Affect Market Outcomes

W

LD

S

$4

500

Price floor$3

A price floor below the eq’m price is not binding – has no effect on the market outcome.

arnab

You can apply the same logic as you did for Price Ceiling to explain why there is no Surplus when the price floor (controlled wage) is below the equilibrium wage.

10

How Price Floors Affect Market Outcomes

W

LD

S

$4

Price floor$5

The eq’m wage ($4) is below the floor and therefore illegal.The floor is a binding constraint on the wage, causes a surplus (i.e., unemployment).

400 550

labor surplus

arnab

Now, the minimum wage exceeds the equilibrium wage. The equilibrium wage (or any wage below $5) is illegal. In this case, the actual wage will be $5. It will not be lower, because any lower wage is illegal. It will not be higher, because at any higher wage, the surplus would be even greater. The actual number of unskilled workers with jobs equals 400. 550 want jobs, but firms are only willing to hire 400, leaving a surplus (i.e. unemployment) of 150 workers. A surplus of anything – especially labor – represents wasted resources.

11

Min wage laws do not affect highly skilled workers. They do affect teen workers. Studies: A 10% increase in the min wage raises teen unemployment by 1-3%.

The Minimum Wage

W

LD

S

$4

Min. wage$5

400 550

unemp-loyment

Impact of Minimum Wage on Employment: Examples from Different Studies

• The Effect of the Minimum Wage on Prices (Lemos, Sara (2004))– It is well established in the international literature that minimum wage increases compress the wages distribution. Firms respond to these higher labor costs by

reducing employment, reducing profits, or raising prices. While there are hundreds of studies on the employment effect of the minimum wage, there is less than a handful studies on its profit effects, and only a couple of dozen studies on its price effects. Not only is the literature scanty on the minimum wage price effects, but also it lacks a survey on that. This survey represents an important contribution to the literature because it summarizes and critically compares over twenty price effect studies, providing a benchmark in the literature. This survey further contributes to the literature by offering an input to the recent debate over the direction of employment effects of the minimum wage. With employment and profits not significantly affected, higher prices is an obvious response to a minimum wage increase. Moreover, this survey also contributes to the literature by extending the current understanding on the minimum wage as a policy against inequality and poverty. If the minimum wage does not cause disemployment but causes inflation, it might hurt rather than aid the poor, who disproportionately suffer from inflation.

• The Response of Hours of Work to Increases in the Minimum Wage (Kenneth A. Couch & David C. Wittenburg (2001))– This paper examines the effect of minimum wage increases on the hours of work of teenagers (ages 16 to 19) using monthly data from the Current Population Survey.

Our findings are consistent with the prediction from neoclassical theory that minimum wage increases have a negative effect on labor demand. However, the estimates we provide here for the elasticity of hours of teen labor demanded with respect to the minimum wage suggest that alternative estimates based on aggregate employment consistently understate the total impact of minimum wage increases on teenage labor utilization.

• Employment Effects of the 2009 Minimum Wage Increase: Evidence from State Comparisons of At-Risk Workers (Saul D. Hoffman & Chenglong Ke (2010))

– In July, 2009, the U.S. Federal minimum wage was increased from $6.55 to $7.25. Individuals in some states were unaffected by this increase, since the state minimum wage already exceeded $7.25 and the state minimum was not increased further. The study uses this variation, as well as variation in the actual amount of the increase, to make comparisons of the employment of “at-risk” workers across states with their peers and within states with workers arguably unaffected by the increase. The data come from the 2009 CPS, four and five months before and after the increase. The study finds some evidence that the employment of some at-risk demographic groups declined as a result of the minimum wage increase, but the impacts are not statistically significant. The study also finds that the employment changes were not responsive to the actual amount of the increase.

• Does Raising the Minimum Wage Help the Poor? (Andrew Leigh (2005))– What is the impact of raising the minimum wage on family incomes? Analyzing the characteristics of low wage workers, this study an increase in the minimum wage

reduces hourly wage inequality (recall that zero hourly wages are ignored). Even in the event that an increase in the minimum wage has only a disemployment effect, and has no impact on hourly wages, it will still have the effect of reducing hourly wage dispersion among those who remain employed.

Consumer Surplus● consumer surplus Difference between what a consumer is willing to

pay for a good and the amount actually paid.

Consumer Surplus and Demand

Consumer Surplus

Consumer surplus is the total benefit from the consumption of a product, less the total cost of purchasing it.

Here, the consumer surplus associated with six concert tickets (purchased at $14 per ticket) is given by the yellow-shaded area.

Consumer SurplusConsumer Surplus and Demand

Consumer Surplus Generalized

For the market as a whole, consumer surplus is measured by the area under the demand curve and above the line representing the purchase price of the good.

Here, the consumer surplus is given by the yellow-shaded triangle and is equal to 1/2 × ($20 − $14) × 6500 = $19,500.

Applying Consumer SurplusWhen added over many individuals, it measures the aggregate benefit that consumers obtain from buying goods in a market.

When we combine consumer surplus with the aggregate profits that producers obtain, we can evaluate both the costs and benefits not only of alternative market structures, but of public policies that alter the behavior of consumers and firms in those markets.

To encourage cleaner air, Congress passed the Clean Air Act in 1977 and has since amended it a number of times.

Valuing Cleaner Air

The yellow-shaded triangle gives the consumer surplus generated when air pollution is reduced by 5 parts per 100 million of nitrogen oxide at a cost of $1000 per part reduced.

The surplus is created because most consumers are willing to pay more than $1000 for each unit reduction of nitrogen oxide.

Consumer Surplus

Consumer and Producer Surplus

Consumer A would pay $10 for a good whose market price is $5 and therefore enjoys a benefit of $5.Consumer B enjoys a benefit of $2,and Consumer C, who values the good at exactly the market price, enjoys no benefit.Consumer surplus, which measures the total benefit to all consumers, is the yellow-shaded area between the demand curve and the market price.



Producer surplus measures the total profits of producers, plus rents to factor inputs. It is the green-shaded area between the supply curve and the market price.Together, consumer and producer surplus measure the welfare benefit of a competitive market.

Consumer and Producer Surplus (continued)

18

Taxes

• The Govt. levies taxes on many goods & services to raise revenue to pay for national defense, public schools, etc.

• The Govt. can make buyers or sellers pay the tax.

• The tax can be a specific amount for each unit purchased or sold, known as “per-unit” or “excise” or “quantity” tax

• When the tax is levied on price it is called Price Tax. A price tax is a per-Rupee (as opposed to per-unit) tax. Also known as Ad Valorem tax– Examples: sales tax, interest tax, value-added tax (VAT)

• For simplicity, we will analyze per-unit or quantity or excise taxes only.

19

S1

EXAMPLE 3: The Market for Pizza

Eq’m w/o tax P

Q

D1

$10.00

500

20

S1

D1

$10.00

500

A Tax on BuyersThe price buyers pay is now $1.50 higher than the market price P. P would have to fallby $1.50 to makebuyers willing to buy same Q as before. E.g., if P falls from $10.00 to $8.50,buyers still willing topurchase 500 pizzas.

P

QD2

Effects of a $1.50 per unit tax on buyers

$8.50

Hence, a tax on buyers shifts the D curve down by the amount of the tax.

Tax

arnab

The government makes buyers pay a $1.50 on each pizza they purchase. The new demand curve (in red, labeled D2) reflects buyers’ demand as a function of the after-tax price. The original demand curve (D1) still reflects buyers’ demand as a function of the total price – inclusive of the tax. Thus, buyers’ demand hasn’t really changed: at each quantity, the height of the original (blue) D curve is still the maximum that buyers will pay for that quantity, while the height of the new (red) D curve is the maximum that buyers will pay sellers for that quantity, given that buyers also must pay the tax. At any Q, the vertical distance between the blue and red D curves equals the tax. (If this were a percentage tax rather than a per-unit tax, the new D curve would not be parallel to the old one, it would be flatter: a tax of a given percentage would be a larger dollar amount at high prices than at low prices, so the downward shift would be greater in absolute terms when P is high than when it is low. This is the type of complexity we avoid by working with per-unit taxes.)

21

S1

D1

$10.00

500

A Tax on Buyers

P

QD2

$11.00PB =

$9.50PS =

Tax

Effects of a $1.50 per unit tax on buyers

New eq’m:

Q = 450

Sellers receive PS = $9.50

Buyers pay PB = $11.00

Difference between them = $1.50 = tax 450

22

450

S1

The Incidence of a Tax:The burden of a tax is shared among market participants i.e., buyers and sellers

P

Q

D1

$10.00

500

D2

$11.00PB =

$9.50PS =

Tax

In our example, buyers pay $1.00 more, sellers get $0.50 less.

23

S1

A Tax on Sellers

P

Q

D1

$10.00

500

S2

Effects of a $1.50 per unit tax on sellers

The tax effectively raises sellers’ costs by $1.50 per pizza.Sellers will supply 500 pizzas only if P rises to $11.50, to compensate for this cost increase.

$11.50

Hence, a tax on sellers shifts the S curve up by the amount of the tax.

Tax

24

S1

A Tax on Sellers

P

Q

D1

$10.00

500

S2

450

$11.00PB =

$9.50PS =

Tax

Effects of a $1.50 per unit tax on sellers

New eq’m:

Q = 450

Buyers pay PB = $11.00

Sellers receive PS = $9.50

Difference between them = $1.50 = tax

25

S1

The Outcome Is the Same in Both Cases!

What matters is this:A tax drives a wedge between the price buyers pay and the price sellers receive.

P

Q

D1

$10.00

500450

$9.50

$11.00PB =

PS =

Tax

The effects on P and Q, and the tax incidence are the same whether the tax is imposed on buyers or sellers: Tax Equivalence

arnab

Whether the government makes buyers or sellers pay the tax, all of the effects are the same: - the price buyers pay rises (in this case to $11) - the price sellers receive falls (to $9.50) - the equilibrium quantity falls (to 450) - the incidence of the tax is the same (here, buyers pay $1 of the tax, while sellers pay $.50 of the tax on each unit)A tax on buyers means buyers will have to pay more, which causes their demand to fall. The fall in demand hurts sellers, forcing them to reduce their price. Similarly, a tax on sellers is like a cost increase, and sellers pass along a portion of that increase to buyers in the form of higher prices. The equivalence of taxes on buyers and taxes on sellers means that we can ignore whether the tax is imposed on buyers or sellers. All that matters is the size of the tax. So, in future problems, we can think of the tax as a wedge between the price buyers pay and the price sellers receive. On a supply-demand diagram, this wedge is a vertical line segment (shown in green on this graph). One last remark: Someone once said “if you want less of something, tax it.” A tax on any good or service causes a fall in its quantity. This is because people respond to incentives: the tax gives buyers an incentive to buy less and gives sellers an incentive to produce less………….One of the principles we talked about in the first class…..

26

Elasticity and Tax IncidenceCASE 1: Supply is more elastic than demand

P

QD

S

Tax

Buyers’ share of tax burden

Sellers’ share of tax burden

Price if no tax

PB

PS

It’s easier for sellers than buyers to leave the market. So buyers bear most of the burden of the tax.

27

Elasticity and Tax IncidenceCASE 2: Demand is more elastic than supply

P

Q

D

S

Tax

Buyers’ share of tax burden

Sellers’ share of tax burden

Price if no tax

PB

PS

It’s easier for buyers than sellers to leave the market. Sellers bear most of the burden of the tax.

28

Incidence of Tax and Deadweight Loss (DWL)

“Tax Incidence and Efficiency Costs of Taxation”; Emmanuel Saez, University of California, Berkely

The Demand function: and The Supply Function :

Pre-Tax Equilibrium

Equilibrium Quantity and Price:

A unit tax of amount “t” is imposed on buyers.

So, post-tax equilibrium

Therefore, Post-Tax equilibrium Quantity: ; and

Post-Tax Equilibrium Prices:

Effect of an Excise Tax: An Algebraic Approach

dB bQaP sS dQcP

dQcbQaQQorPP sdSB

dbcaQand

dbbcadP EE

tdQcbQatPP SB

dbtQQ E

tEt

tdb

dPPandtdb

bPP ESEEBE

)()(

lecture 7 - price effect and government intervention_bi

Documents