Interventions on Supply and Demand

Fred E. Foldvary

Chapter 6, Supply, Demand, and Government Policy

Price support, price floor: price > marginal market price.

Floor means you can't legally sell below that price, or pay wages lower than that minimum.

Example: minimum wage.

What is the purpose of legislating a minimum wage?

It is to raise wages of the least able workers to a higher level; this makes the price control binding,

meaning it alters the price.

It does artificially raise the wage of some workers, but the quantity of labor supplied becomes greater than the quantity demanded.

The result is a labor surplus, or unemployment, or else an underground, illegal price.

In some cases, the worker is not laid off, but the employer provides fewer benefits, since only the explicit wage is controlled, not the implicit wages in the form of benefits and training.

The least able workers are hit hardest: teenagers, first-time workers, low-income minorities.

Net wages of all workers are also reduced to pay for unemployment compensation and welfare.

Prices of goods rise as costs get passed on to consumers.

There is a deadweight loss - a reduction in well being caused by a misallocation of resources -

to consumers and producers.

Q: what would be a more effective way to increase the wages of the poor?

A government-set quantity control has a similar effect of a price control.

If the legal quantity is less than the market quantity, the supply becomes vertical at the legal limit, and the price is raised. In this case, however, the quantity demanded equals the quantity supplied because the supply has been restricted by the intervention. The deadweight loss to the economy is nevertheless the same as with a price control.

Price ceiling: price < marginal market price.

The seller may not legally have a price above the ceiling.

(Think of the ceiling BELOW the floor of a 2nd -story building.)

Rent control is a common example.

It results in a shortage, waiting lists, and underground markets.

It's really a rental control of all the factors, land, labor, and capital, of the owner.

At first, rent control reduces the land rent obtained by the landlord.

One result is that, with a shortage of rental apartments, landlords are able to discriminate on the

basis of arbitrary criteria such as race and ethnic origin.

But if the price control falls farther from the market price, it then cuts into the return on capital goods, and the result is less maintenance and the deterioration of the building.

If this goes too far, the landlord abandons the building, or (illegally) burns down an abandoned building.

Land rent cannot be reduced by legislation. Why?

One can only control the legal rental paid by tenants.

It would be better to call it a control of the legal rental.

The landlord is also a capital lord and a worker lord.

The result is a shortage. Waiting lists. A deadweight loss.

Can lead to underground or black market if due to controls.

Landlords are better able to discriminate.

Lower profits from capital goods lead to fewer apartments built and reduced maintenance.

Rent controls lead to housing shortages, underground markets, deteriorating structures, a stoppage of construction, big inequalities.

What is the effect on the poor of removing rent controls?

They don't necessarily become homeless; they can move to lower-rent areas, to smaller apartments,

to shared housing, or get more income.

Legal restrictions such as zoning and tenant controls often prevent these market-based responses.

Q: what would be a more effective way of making housing more affordable?

A: remove restrictions on building (such as zoning and building codes) and untax wages.


The incidence of taxation: the distribution of the ultimate tax burden.

Effect of sales taxes: shifts supply of goods to the left.

There is a similar effect from income taxes.

The "tax wedge" is the difference between the price paid by the buyer and the price obtained by the seller. There is a tax wedge on taxes on wages, the difference between the cost of labor and what a worker earns net of taxes.

Increases price, reduces quantity, hence employment.

The burden is shared by the buyer and seller.

The incidence depends on the supply and demand elasticity, and not on the government law

specifying who pays the tax.

The payroll tax - social security or FICA - is officially divided between employer and employee, but the incidence of the tax depends on the elasticities, so not necessarily 50-50.

The less elastic the demand, the greater the burden on the buyer or tenant.
The less elastic the supply, the greater the burden on the seller or provider or owner.