(Note: Skip pages 87-92).  

ECONOMICS OF PRICE CONTROLS: REPEALING THE LAWS OF S AND D (p. 92)

When prices are unregulated, market forces (S and D) will exert strong and relentless pressure to move the price toward equilibrium, resulting in the "market clearing" outcome: Q_d = Q_s.  When Q_d = Q_s, the market is in balance or equilibrium, meaning that there are NO SHORTAGES and NO SURPLUSES.  Market equilibrium is efficient and socially desirable because it eliminates shortages and surpluses, which are considered to be economically inefficient and undesirable.

Think of the stock market, which is considered to be close to the economic ideal of an "efficient market", a market that continually clears.  Prices are set in an "auction" type setting, by buyers and sellers.  When there is "buying pressure" in the stock market, what happens to prices?  What about when there is "selling pressure"?  Stock market prices continually adjust during trading, and the fluctuating prices bring about continual market equilibrium.  Stock prices adjust to "clear the market."

When have you ever heard of a "shortage" or "surplus" of GM stock?  Never, because the market price continually adjusts up and down to eliminate any shortages or surpluses of GM.  For example, assume that there was a temporary surplus of GM stock on the market (more sellers than buyers at a given price), what would happen to the price of GM?  What if there was a temporary shortage (more buyers than sellers at a given price) - what would happen to the price?

The stock market may be more efficient than some markets, since prices change by the minute in the stock market and there are many markets where prices don't change daily.   For example, think of the labor market, prices (wages) may be fixed for years at a time in a union contract.  Even if markets don't have continual market clearing like a stock market, the market forces are still in effect, and are moving the prices towards equilibrium.  Even if it takes years to reach equilibrium, or even if a market never actually reaches equilibrium, we still want to understand the direction that the market is moving towards.  Market forces (when prices are unregulated) are always pushing the market towards equilibrium, markets are always "gravitating" towards the equilibrium outcome.

There are some cases when prices are NOT allowed to freely fluctuate according to market forces, but are fixed above or below the market price with a government mandated PRICE CONTROL.  When the price is fixed BELOW the market price, it is called a PRICE CEILING.  The most common example of a price ceiling is RENT CONTROL, which is in effect in over 200 cities in U.S., and in many cities around the world.  Price Ceiling sets a MAXIMUM PRICE that can be charged by law.  Prices above the maximum price ceiling are illegal.

See page 93.  Market price is P₀, the Price Ceiling results in an artificially low price of P₁.  At a price of P₀, the market clears, Q_d = Q_s, there is a balance between S and D, there are no shortages or surpluses, the market is in equilibrium.

At an artificially low price of P₁, there is a shortage because Q_d > Q_s.  Assume that the market clearing price (rent) is $900/month for a 1BR apartment, and rent control laws set the rent at $500.  The general goal of rent control is promote "affordable housing" and protect tenants from high rents.

But think of the change in incentives that will now cause a "housing shortage" in cities with rent control.  At $900/month, tenants will have an incentive to conserve on housing space, live with several roommates, live at home as long as possible, etc.  At an artificially low price of $500, now tenants would rather live by themselves, or move from their parents home into an apartment.  In other words, at $500 the Q_d increases.  At $900/month, landlords will have incentive to provide more housing than at $500.  If a building owner can only get $500/month, they will have little incentive to provide housing, and there will be very little incentive to build more housing.  In other words, the Q_s decreases significantly at $500.  Therefore, the Q of apartments demanded by tenants will be much greater than the Q of apartments supplied by landlords, resulting in a "housing shortage."

See pages 93 and 95 for an analysis of Rent Control Laws.

Results of Rent Controls:
1. Housing shortages will develop (Q_d > Q_s) and black markets will result.  Example: Rent is $500 month, but the tenant pays a $2000 "key charge" as a way around the price control.
2. The future supply of housing will decline, since there is no incentive to build rental housing AT market prices if the rental income will be BELOW market prices.
3. The quality of rental housing will deteriorate.  A seller can effectively raise prices by either a) raising the monetary price or b) reducing quality (or size).  Example: Mars candy - raise price or reduce size (or quality) of candy bars.  Landlords will respond to rent controls by reducing quality of rental housing, fewer repairs, less remodeling/painting, etc.
4. Nonprice methods (discrimination) of allocating housing will increase.  Since rent controls result in housing shortages, there could easily be dozens of tenants trying to rent each available rent-controlled apartments when they become available.  Faced with dozens of tenants desperate for the apartment, the landlord will find it much easier to discriminate against anyone they don't like - families, minorities, unconventional lifestyles, etc.  Rent control lowers the cost of discrimination, resulting in more discrimination.
5. Inefficient use of housing.  Rent control results in extremely low turnover of housing.  Nobody wants to give up a rent-controlled apartment, it becomes a valuable asset.  Example: Family with a 4BR apartment, kids grow up and move out, the parents don't need a 4BR apartment but won't move from their rent-controlled apartment.
6. Long term renters with rent-controlled apartments benefit at the expense of newcomers.  If we move to NYC today, we may not be able to find housing because all affordable housing is already taken by the existing tenants.  Example:  Former NYC mayor Ed Koch lived for 12 years in Gracie Mansion, the official mayor's residence, but kept his $440/month rent controlled apartment.

Summary:  Despite its intentions to benefit tenants and create affordable housing, the overall effects of rent controls are generally disastrous for most tenants - housing shortages, declining quality of housing, inefficient use of housing, increases in discrimination, etc.
 

APPLICATION: PRICE CEILINGS DURING HURRICANE HUGO, p. 94

Artificially low prices (price ceilings) were imposed by government on ice, plywood, food, generators, etc. Although well-intentioned, price controls after a disaster typically make a bad situation worse, like after Hurricane Hugo.  

PRICE FLOORS: MINIMUM WAGE

A price floor sets a MINIMUM PRICE, making it illegal to pay or receive a price (wage) below the Price Floor.  The Minimum Wage is the most common example of a legally enforced price floor.  Farm price supports are another example of a price floor.

See page 97 and 98 for an graphical analysis of Price Floors and Minimum Wage laws.  Price floors result in a SURPLUS, since at the artificially high price (wage), the Qs > Qd.  In the labor market, what is a surplus of workers called???

The market clearing wage for unskilled workers is $4/hour on p. 98, resulting in Q_d = Q_s, Un Rate = 0%.  If the legal minimum wage is set at $5.15, two things happen:  Q_s goes up since more people will be willing to work at $5.15 than $4.  Q_d goes down since employers will be willing to hire fewer workers at $5.15 than $4.  Result: Q_s > Q_d.  Minimum wage law = unemployment.

How would employers respond to higher minimum wages?  Lay off workers, hire fewer workers in future.  Other possible adjustments to offset higher wages: Cut hours, have employees work at less convenient times (split shift from 11 am- 1pm and 4pm-7pm instead of 11-7pm), reduce benefits like paid holidays and free uniforms, reduce on-the-job training, etc.  In other words, the NON-WAGE factors of a job will be reduced.

Another effect: Increase in discrimination.  For every job opening there might be dozens of applicants, making it much easier (less costly) to discriminate against minorities, unconventional lifestyles, etc.  Economist Milton Friedman has called the Minimum Wage law "the most anti-black law on the books," because of its disproportionate negative effect on blacks, especially black teenagers.  Teens are the group most affected by the Min Wage, and teen unemployment is generally 3x the national average, and the unemployment for black teens has been close to 30% recently.

Summary: Although well-intentioned (to help unskilled workers), the Min Wage law, like Rent Control laws, has serious unintended, adverse consequences for the very group that the law is designed to help - unskilled workers.   The Min Wage prices unskilled workers out of the labor market, causing many to be unemployed and unable to develop the work habits and skills that would allow them to move beyond the unskilled labor market and achieve higher wages.

Economists generally are opposed to price controls because of the distortions that result (shortages and surpluses), and generally favor unregulated market prices because of their ability to clear markets and eliminate shortages and surpluses.
 

THE IMPACT TAXES ON MARKET TRANSACTIONS

Who bears the burden of a tax, what is the Tax Incidence? Tax incidence tells us how the payment of the tax is distributed between the buyer and seller.  The tax can be assessed, and paid by,  either the buyer or seller, but the tax incidence generally is split between the buyer and seller.  That is, the buyer absorbs part of the tax and the seller absorbs part of the tax.

Tax Base:  The amount of an economic activity subject to the tax.  Generally, increased (decreased) taxes shrink (expand) the Tax Base.

Tax Rate: The percentage or per-unit rate at which the economic activity is taxed.  Examples: 6% sales tax, 28% income tax, 20% capital gains tax, 15 cents/gallon gas tax, etc.

Example of The Impact of Tax on Sellers, see page 101.  Govt. imposes a $1000 tax per used car sold, and requires that the seller of the used car submit the tax to the govt.  Before the tax, used cars sell for $7000 and 750 cars are sold per month.  The $1000 tax on sellers shifts the Supply curve back (DECREASE).  The graph shows ONE possible outcome (out of many outcomes, depending on S and D curves, elasticity, etc.).

Results of $1000 tax on sellers:

1. Car prices rise to $7400
2. Car sales fall to 500/month. (Tax base shrinks)
3. Buyers pay $400 more per car ($7000 to $7400)
4. Sellers receive $600 less per car (Sellers collect $7400, buy pay $1000 tax to govt., net $6400 per car vs. $7000 before).
5. Tax incidence: 40% of tax is paid for by buyers and 60% of tax is paid by sellers.
6. Tax collected: 500,000 cars X $1000/car = $500m per month
7. There is a Deadweight Loss (DWL) or Excess Burden of Taxation as a result of the tax, reflecting the value of the lost trade because of the tax.  DWL is the value of the trade that WOULD have taken place but does NOT take place now because of the tax.  The triangle ABC is the exact amount of DWL.

Consumers are worse off because a) those who buy cars now pay higher prices and b) some consumers (250,000 / month) are now priced out of the market and don't buy a car at all.  Producers are worse off after the tax because they sell fewer cars and receive less money per car compared to before.  Therefore the DWL represents the LOSS OF CONSUMER SURPLUS + LOSS OF PRODUCER SURPLUS.   The tax revenue is not lost, it is just a transfer of income from car buyers and car sellers to the government, but the DWL is the amount of lost trade - the mutually beneficial exchange that now does NOT take place.

What if the $1000 is placed on the car buyers instead of the car seller?  Every car buyer has to send in a $1000 tax to the government.  Does this change anything???  Answer: NO!

See page 103 for the Impact of a Tax on Buyers.  Now the Demand curve shifts back (DECREASES) reflecting the $1000 tax, but the net result is exactly the same as before: Buyers pay $400 (40%) and Sellers pay $600 (60%).  The number of cars sold, the price, the revenue to the government, the DWL, etc. is EXACTLY the same as before.

MAIN POINT: Tax incidence (burden) is independent of the assignment of the tax on buyers or sellers.
 

ISSUE: What determines Tax Incidence?  Elasticity of Demand VS. Elasticity of Supply, the responsiveness/sensitivity of buyers and sellers to price changes.

If consumers are extremely price sensitive, they will not be receptive to price increase from taxes, and the burden of taxes will fall disproportionately on sellers.  If consumers are price insensitive, they will more willing to bear the burden of taxation.

Examples:  1) Demand for gasoline is generally considered relatively Inelastic (few substitutes), so that consumers will bear a greater burden of gasoline taxes.  With a 20 cent gasoline tax, consumers may bear 15 cents and sellers only 5 cents per gallon.  Page 105.

2) Demand for luxury yachts built in U.S. is considered extremely Elastic (many substitutes - buy a yacht in Mexico, Canada, Bahamas, etc.), therefore the incidence of the $25,000 luxury tax on yachts (1990) fell mainly on yacht sellers.  Buyers paid only $5000 and sellers absorbed $20,000 of the tax.  Result: yacht sales fell dramatically, employment in yacht industry fell, massive layoffs, etc.  Tax was repealed because of the unintended adverse effect on yacht industry.
 

TAX RATES, TAX REVENUES AND THE LAFFER CURVE

Income Taxes Application.   Concepts:

Average Tax Rate = Taxes Paid / Taxable Income.  If you pay $3000 tax on $20,000 income, your average tax rate is 3000 / 20,000 = .15 or 15%.

Proportional Tax (Flat Tax) = Like a 6% sales tax, where a uniform tax rate applies to all levels of income (or purchases). Example: Flat tax of 17% on ALL levels of income.

Progressive Income Tax = Current system in U.S. and most other countries and states in U.S.  The tax rate progressively INCREASES as income increases.  Example: Tax rate of 10% on income between 0-$10,000, 20% tax rate on income between $10,000 - 20,000, 30% tax rate on income between $20,000-50,000, etc.

Regressive Tax =  The tax rate DECREASES as income increases.  Using the data from above for the Progressive Tax, the Regressive Tax would go from 30% to 20% to 10%, instead of from 10% to 20% to 30%.  Example: Social Security tax is considered "regressive" because there is a MAX amount of income that is subject to SS Tax = $65,000.  Therefore someone making $65,000 and someone else making $650,000 would both pay the same SS tax, which would be regressive because the percentage of income going to SS for the person making $650,000 would be LOWER than for the person making $65,000.

Marginal Tax Rate = CHANGE in Taxes / CHANGE in Income, reflecting how much tax is paid on MARGINAL , or additional Income.  People are generally concerned with their highest marginal tax rate, since that would most affect their decisions.  Example: Two physicians are married.  One spouse is working and their income puts them in the highest marginal tax bracket, say 35%.  When making a decision about whether the second spouse should work or not, work full-time or part-time, etc. the relevant tax rate is the Marginal Tax, since it applies to the additional or marginal income of the second spouse.  Or an accountant is in the 35% tax bracket with his/her regular salary, and they consider an opportunity to make $1000 in outside consulting or income tax work on Saturdays.  After tax, they only receive $650 ($1000 - $350 tax), so they have to consider their Marginal Tax rate.  It would be a mistake to for them to consider their Average Tax Rate for example.
 

LAFFER CURVE

How do changes in Income Tax Rates (%) affect the Tax Revenue ($) collected?  If income tax rates (%) go UP, does Tax Revenue ($) collected go UP or DOWN?   It depends.  Laffer Curve illustrates graphically the relationship between Tax Rates and Tax Revenues.  See book page 107.

At tax rates of 0% and 100%, no tax revenues would be collected.  Why???  Starting from 0%, increases in the tax rate will initially increase tax revenues.  Beyond point B, increases in the tax rate will decrease tax revenue collected.  Why?  Because at Point B, DISINCENTIVES start to take effect, and increases in the tax rate will DECREASE the TAX BASE.  There will be fewer hours worked, less income reported, and an overall reduction in the tax base, leading to a reduction in tax revenue.

Alternatively, when tax rates are very high, Point C (75% tax rate) for example, a REDUCTION in TAX RATES will actually INCREASE TAX REVENUES.  Why?  Because there will be increased incentives to work, engage in productive activity, report income, etc., increasing the TAX BASE.

Example: In the early 1980s, there were 14 tax progressive marginal tax brackets, up to 70%.  Major tax reform simplified income tax system to just two tax marginal income tax brackets - 15% and 28%.  Result: As Laffer curve predicts, REDUCING the marginal tax rates, INCREASED the Tax Base, and INCREASED Tax Revenue, especially for the top 1%.

See page 109 for a comparison between 1980 and 1990.  The top 1% paid $87.2B in taxes 1990 compared to $57.6B in 1980, 51% increase.  Top 10% also paid more in 1990 compared to 1980, supporting the Laffer curve.