CHAPTER 6Government Actions

in Markets

Learning Objectives

Explain how price ceilings create shortages and inefficiency (example, rent control)

Explain how price floors create surpluses and inefficiency (example, minimum wage)

Price Ceilings

A Regulated Housing Market

Price ceilings are regulations that make it illegal to charge a price higher than a specified level.

Rent ceilings (sometimes called rent control) are price ceilings applied to housing markets.

How does a rent ceiling affectthe housing market?

A Regulated Housing Market

Rent ceilings set above equilibrium have no effect.

Rent ceilings set below equilibrium prevents price from regulating the quantities supplied and demanded.

No Rent Ceiling

Quantity (thousands of units per month)

Ren

t (do

llars

per

uni

t per

mon

th)

0 36 72 100 150

1200

1600

2000

2400

D

S

Rent Ceiling

Instead of letting the housing market adjust normally (P*=2000, Q*=72), suppose a rent ceiling of $1600 per month was imposed.

A Rent Ceiling

Quantity (thousands of units per month)

Ren

t (do

llars

per

uni

t per

mon

th)

0 36 72 100 150

1200

1600

2000

2400

D

S

Rentceiling

A Rent Ceiling

Quantity (thousands of units per month)

Ren

t (do

llars

per

uni

t per

mon

th)

0 36 72 100 150

1200

1600

2000

2400

D

S

Rentceiling

Housingshortage

Effects of a Rent Ceiling

Because of the housing shortage, black markets develop. The maximum black market rent would be $2400.

A Rent Ceiling

Quantity (thousands of units per month)

Ren

t (do

llars

per

uni

t per

mon

th)

0 36 72 100 150

1200

1600

2000

2400

D

S

Rentceiling

Housingshortage

Maximum black market rent

Effects of a Rent Ceiling

For those who abide by the rent ceiling law, there is no incentive to maintain the existing housing stock. As a result, housing quality falls.

There is also no incentive to build new housing. Thus, a permanent shortage of housing could exist.

Quantity (thousands of units per month)

Ren

t (do

llars

per

uni

t per

mon

th)

0 36 72 100 150

1200

1600

2000

2400

D

2800S

No Rent Ceiling

No Regulation -

Efficient

Quantity (thousands of units per month)

Ren

t (do

llars

per

uni

t per

mon

th)

0 36 72 100 150

1200

1600

2000

2400

D

2800S

No Rent CeilingConsumer

Surplus = .5(72x800)=28800

Quantity (thousands of units per month)

Ren

t (do

llars

per

uni

t per

mon

th)

0 36 72 100 150

12

16

20

24

D

28S

No Rent Ceiling

Producer

Surplus=.5(72x800)=28800

Consumer

Surplus = .5(72x800)=28800

Quantity (thousands of units per month)

Ren

t (do

llars

per

uni

t per

mon

th)

0 36 72 100 150

12

16

20

24

D

28S

No Rent Ceiling

Producer

Surplus=.5(72x800)=28800

Consumer

Surplus = .5(72x800)=28800

No Regulation -

Efficient

Consumer Surplus

+Producer Surplus =57600

Quantity (thousands of units per month)

Ren

t (do

llars

per

uni

t per

mon

th)

0 36 72 100 150

1200

1600

2000

2400

D

Rentceiling

2800S

Inefficiency of Rent Ceiling

Rent Ceiling

at $1600

Supply at rent ceiling

Rent Ceilings

100,000 units will be demanded. A shortage of 64,000 units will be

created.

Quantity (thousands of units per month)

Ren

t (do

llars

per

uni

t per

mon

th)

0 36 72 100 150

1200

1600

2000

2400

D

Rentceiling

2800

S

Inefficiency of Rent CeilingConsumer Surplus

=.5(36X400)+(36x800)=36000

Quantity (thousands of units per month)

Ren

t (do

llars

per

uni

t per

mon

th)

0 36 72 100 150

1200

1600

2000

2400

D

Rentceiling

2800

Producersurplus=.5(36x400)=7200

Inefficiency of Rent CeilingConsumer Surplus

=.5(36X400)+(36x800)=36000

S

Quantity (thousands of units per month)

Ren

t (do

llars

per

uni

t per

mon

th)

0 36 72 100 150

1200

1600

2000

2400

D

Rentceiling

2800

Deadweightloss=.5(800x36)=14400

Inefficiency of Rent Ceiling

Producersurplus=.5(36x400)=7200

Consumer Surplus

=.5(36X400)+(36x800)=36000

S

Effects of a Shortage When quantity demanded exceeds

quantity supplied, the smaller quantity will be the one actually bought and sold, many suppliers have nothing to sell, and many buyers find there is nothing to buy.

36,000 units are available. Demand for the additional 64,000

units is unsatisfied.

A Housing Market with a Rent Ceiling

Are Rent Ceilings Fair?According to the fair rules view, a rent ceiling is unfair because it blocks voluntary exchange.According to the fair results view, a rent ceiling is unfair because it does not generally benefit the poor.A rent ceiling decreases the quantity of housing and the scarce housing is allocated by Lottery First-come, first-served Discrimination

A Housing Market with a Rent Ceiling

A lottery gives scarce housing to the lucky.A first-come, first served gives scarce housing to those who have the greatest foresight and get their names on the list first.Discrimination gives scarce housing to friends, family members, or those of the selected race or sex.None of these methods leads to a fair outcome.

Price Floors

Labor Markets andMinimum Wages

The interaction of demand and supply in the labor market influences the jobs we get and the wages we earn.

Firms make decisions about the quantity of labor to demand.

Households make decisions about the quantity of labor to supply.

An UnregulatedLabor Market

The wage rate balances the quantity demanded and the quantity supplied, determining the level of employment.

A Market for Low-Skilled Labor

Quantity (millions of workers)

Wag

e R

ate

(dol

lars

per

hou

r)

20 21 22 23

3

4

5

6 S

D

The Minimum Wage

A minimum wage law is a regulation that makes hiring labor below a specified wage illegal.

In the U.S., the current federal minimum wage is $7.25/hour

Most states also have minimum wages. About 40% of the states have minimum

wages above the federal minimum. The larger of the federal or state minimum

is the one that applies to workers in that state.

Effective and Ineffective Minimum Wage Laws

If the minimum wage is set below the equilibrium wage, it has no effect.

If the minimum wage is set above the equilibrium wage, the minimum wage law is in conflict with market forces.

Effects of an Effective Minimum Wage Law

An effective minimum wage causes the supply of labor to exceed the demand for labor.

The excess supply of labor (surplus) is called unemployment.

The unemployed workers are searching for jobs. The unemployed are comprised of two groups

(layoffs and new entrants). In our example each of these groups has 1 million

workers for a total of 2 million unemployed. The minimum wage is inefficient and creates a

deadweight loss.

No Minimum Wage

Quantity (millions of workers)

Wag

e R

ate

(dol

lars

per

hou

r)

20 21 22 23

3

5

7

9 S

D

Minimum Wage and Unemployment

Quantity (millions of workers)

Wag

e R

ate

(dol

lars

per

hou

r)

20 21 22 23

3

5

7

9 S

D

Minimumwage

a b

Unemployment

LayoffsNew entrants

Minimum Wage and Deadweight Loss

Quantity (millions of workers)

Wag

e R

ate

(dol

lars

per

hou

r)

20 21 22 23

3

5

7

9 S

D

Minimumwage

a b

Unemployment

Deadweight loss

The Minimum Wagein Reality

Minimum wage laws hit low-skilled workers the hardest, especially the young with few job skills.

The unemployment rate for teenagers is consistently more than twice the national average.

The actual minimum wage is zero, the wage earned by the unemployed.

Projected Effects of President Obama’s Proposed Increase in the Minimum Wage (CBO Estimates)