Applications to Major Economic
Issues Cont’d
(chapter 4, cont’d)
In today’s lecture:
• We will continue our topic on how the
previously studied economic tools (supply,
demand, and elasticity) can assist our
understanding of many policy issues.
• Specifically, we will analyze the consequences
of various types of government intervention
in markets.
MINIMUM PRICES “FLOORS”
AND MAXIMUM PRICES “CEILINGS”
• Sometimes, rather than taxing or subsidizing a
commodity, the government legislates
maximum or minimum prices.
• In some cases, for example, the government
can impose price floors, as in the case of the
minimum wage.
• In other cases, it can impose price ceilings to
prevent spiraling inflation.
• This kind of government intervention with the
laws of supply and demand are different from
those in which the government imposes a tax and
then lets the market act through supply shifts.
• Setting maximum or minimum prices in a market
tends to produce perverse economic effects,
through the creation of price distortions.
• Adam Smith: “most economic systems are
plagued by inefficiencies stemming from well-
meaning but inexpert interferences with the
mechanisms of supply and demand.”
A. The Minimum-Wage Controversy:
• The minimum wage: sets a minimum hourly
rate that employers are obliged to pay
workers.
• This is an issue that divides economists.
– Nobel laureate Gary Becker stated, “Hike the
minimum wage, and you put people out of work.”
– Another group of Nobel Prize winners: “We
believe that the federal minimum wage can be
increased by a moderate amount without
significantly jeopardizing employment
opportunities.”
Let’s look at the following figure which depicts
the market for unskilled workers.
It is clear from the previous figure that:
• A minimum wage rate is set above the market-
clearing equilibrium wage,𝑊𝑚𝑎𝑟𝑘𝑒𝑡 , resulting
in movement along the demand curve to E,
with a fall in employment.
• The gap between the number of labor
supplied and that demanded is shown as U,
representing the amount of unemployment
created by this policy.
• Using supply and demand, we can see that
there is likely to be a rise in unemployment
and a decrease in previous employment of
low-skilled workers.
– But how large will these magnitudes be?
– And what will be the impact on the wage income
of low-income workers?
• On these questions, we need information on
elasticities. This is given by empirical
evidence.
• Empirical studies concluded that the demand
for low-skilled workers is price-inelastic
(between 0.1 and 0.3).
• Given these elasticities, a 10% increase in the
minimum wage will increase the incomes of
low income workers by 7 to 9 percent, despite
the decline in their total employment.
– This can be seen by comparing the income
rectangles under the equilibrium points E and M .
The “impact on incomes” Argument:
• Those who are particularly concerned about the
welfare of low-income groups may feel that
modest inefficiencies are a small price to pay for
higher incomes.
• Others—who worry more about the impact of
higher costs on prices of final goods, on profits of
businesses, and on international
competitiveness—see that the inefficiencies are
too high a price.
– Those believe that the minimum wage is an inefficient
way to increase the incomes of low-income groups;
they prefer using direct income transfers rather than
gumming up the wage system.
How important are each of these concerns to
you?
Depending upon your priorities, you might •
reach quite different conclusions on the
advisability of increasing the minimum wage.
B. Energy Price Controls
• Another example of government intervention
comes when the government legislates a price
ceiling.
• Example: Suppose there is suddenly a sharp
rise in oil prices because of any of the
following:
– Reduced cartel supply and booming demand.
– Political disturbances in the Middle East due to
war or revolution.
What do you think will the response of politicians
be?
• Politicians, seeing the sudden jump in prices, will
rise to denounce the situation.
• They claim that consumers are being “squeezed”
by profiteering oil companies.
• They worry that the rising prices threaten to
ignite an inflationary spiral in the cost of living.
• They fear about the impact of rising prices on the
poor and the elderly.
• They call upon the government to “do
something.”
What do you think the response of the
government will be?
• In the face of rising prices, the government
might be inclined to listen to these arguments
and place a ceiling on oil prices.
What are the effects of such a ceiling?
Note that the initial equilibrium before the shock was
at K
a) Impact of the supply shock without government
intervention:
• Because of a drastic cut in oil supply (leftward
shift in supply curve), the market price of
gasoline would rise sharply, with the post-shock
equilibrium given by E
• In other words, the market will operate freely,
and would clear at a price of perhaps $3.50.
• Consumers would complain but would willingly
pay the higher price rather than go without fuel.
b) Now consider the gasoline market with intervention:
• Suppose the government passes a law setting the
maximum price for gasoline at the old level of $2 a
gallon.
• At the legal ceiling price, quantities supplied and
demanded do not match (shortage)… Consumers
want more gasoline than producers are willing to
supply at the controlled price.
• Moreover, the market does not “clear”. Why? Because
it is against the law for sellers to charge the
equilibrium price of $3.50.
• This generates a period of frustration and shortage.
What will the government do to ration
demand?
1. Rationing by the “queue.”
• Because time is valuable, the length of the line
will serve as a kind of price that limits
demand.
• We saw rationing by the queue
in markets like gas cylinders.
• This is a wasteful system because much
valuable time is spent waiting in line.
2. Coupon Rationing:
• Under coupon rationing, each customer must
have a coupon as well as money to buy the
goods.
• When rationing is adopted, shortages
disappear because demand is limited by the
allocation of the coupons.
• From the graph, suppose the government
hands out coupons corresponding to quantity
CJ. Then, supply and the new demand balance
at the ceiling price of $2.
3. Marketable Coupons:
• With a supply curve RR, the new market
equilibrium price of gasoline is $5 per gallon,
where you pay $2 for the gasoline and $3 for a
coupon.
• The price has indeed risen, but in an indirect way.
• Additionally, people with coupons have been
given a new form of income in coupons.
• Note that because of the price control, quantity
supplied is still at the old level, but the total price
including coupons ($5) is actually higher than the
original equilibrium price without rationing
($3.50).
To sum up:
• The inefficiencies of government interventions
eventually overwhelm whatever favorable
impacts the controls might have on
consumers.
• Consequently, price controls on most goods
are rarely used in most market economies.
Lesson to be learnt:
• Goods are always scarce. Society can never
fulfill everyone’s desires.
• In normal times, price itself rations the scarce
supplies.
• When governments step in to interfere with
supply and demand, prices no longer fill the
role of rationers.
• Waste and inefficiency are the result of such
interferences.